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The short version

  • Speculative investing is the purchase of high-risk assets based on price fluctuations and “hunches” over solid fundamentals. It’s often compared to gambling.
  • Modern examples include crypto, GameStop stock, and angels/VCs investing in unproven startups.
  • Speculative investing gets a bad rap for causing bubbles and recessions and for burning amateur investors
  • But it also moves our economy forward by improving float, funding ESG companies, and backing startups that become blue chips, like Google and Alibaba.
  • As a speculative trader, you can hedge your risk through “sandbox” paper trading or by limiting your exposure to 5% of your overall portfolio.

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What is a speculative investment?

According to The Commodity Futures Trading Commission, a speculative investor, or “speculator,” is: “A trader who does not hedge but who trades with the objective of achieving profits through the successful anticipation of price movements.”

In Olde Millennial English, a speculative investment is:

  • High-risk
  • High-reward
  • Focused on short-term gains
  • Typically based on a “hunch” more than any solid fundamentals

Here are some classic examples of speculative investments:

Startups such as Facebook and Alibaba

In 2004, a shy college kid managed to score a pitch meeting with VC titans Reid Hoffman and Peter Thiel — but he didn’t put on much of a show.

“We weren’t blown away by his pitch… there was a lot of staring at the desk, not saying anything,” said Hoffman in a later interview.

But the kid’s website was gaining ground unusually quickly on college campuses, so Thiel decided to throw in $500,000 for 10% of the company and a board seat. Eight years later, he sold 75% of his Facebook shares for $400 million. If he hadn’t cashed out during Facebook’s disastrous IPO, his shares would now be worth $3.6 billion.

Angels and VCs thrive on speculative investments. Even if they back stinkers 95% of the time, all they need is a handful of winners — or a single home run — to bankroll the next several years.

Another famous example was Softbank’s investment in Alibaba in 1999. Jack Ma was surprised by his first meeting with Softbank founder Masayoshi San. “We didn’t talk about revenue, we didn’t even talk about a business model, we just talked about a shared vision.”

So what inspired Masayoshi Son to invest $20 million in Alibaba for a 34% stake, which would later be worth $60 billion? It was all because of a hunch: “I invested based on my sense of smell,” he recalls.

More: How to invest in startups

GameStop (GME) in 2020-2021

Ironically, modern history's greatest speculative investing frenzy started in a pretty non-speculative way.

On July 27th, 2020, CFA and former MassMutual educator Keith GIll posted an hour-long deep dive into GME’s fundamentals, eventually reaching the calm, justified conclusion that the stock was undervalued.

Months passed before the video reappeared on Reddit, where it spread like wildfire. Soon, thousands of amateur investors were downloading Robinhood to buy shares of GME. Prices skyrocketed, the promise of instant riches beckoned, and hundreds of first-timers flooded the market.

Ninety-nine percent of these investors weren’t buying GME based on Gill’s fundamental analysis or any technical assessment of their own. They saw an opportunity for sky-high short-term gains, and they seized it. That’s not to say they were all amateurs — even professionals will spot and ride the hype train for an easy buck.

Cryptocurrency

As a crypto investor, I’m about to say something that’ll probably get me banned from visiting El Salvador: All cryptocurrency investments are speculative because crypto lacks fundamentals.

You can’t fit crypto into an asymmetric risk profile because the risk is incalculable. Bitcoin could hit $100,000 this year or $1,000, and there’s virtually no way to know how it will go. Ergo, a crypto investment can’t be anything but speculative.

Sure, some fundamentals exist — you can read technical white papers and look at historical pricing data (as flimsy as it is) — but again, there just ain’t enough meat on them bones to make a predictable, non-speculative play.

Now, does this all mean that you should avoid speculative investing like a REIT in 2008? Not necessarily. Before considering whether you should dabble in speculative investing, there’s more context you should know first.

More: What does HODL mean in crypto and stocks?

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Investing vs. Speculating

When it comes to investing and speculating, there are a few key differences that you should be aware of. For starters, investors typically have a longer-term outlook than speculators. They may be looking to purchase an asset and hold onto it for years, or even decades, in order to see appreciation. In contrast, speculators are often more interested in shorter-term gains and may be more likely to “flip” an asset – selling it quickly after purchase for a profit.

Another key difference has to do with risk toleranceInvestors are typically more risk-averse than speculators. They may be more conservative in their approach, looking for opportunities that offer a solid return without too much volatility. Speculators, on the other hand, may be more willing to take on riskier bets in hopes of earning a bigger payoff.

Finally, it's important to remember that there's not a black and white line that separates investing from speculating. Rather, it's more of a spectrum. Even among assets that are considered sound long-term investments, some are more volatile than others. More volatility means a greater potential for both profits and losses. When you're investing, it's important to consider your risk tolerance and invest in assets that align with your goals.

How can speculative investing weaken the stock market & economy?

When speculation is rampant, it can create a “bubble” in the market, where prices become artificially inflated. This can lead to a sharp drop in prices when the bubble finally bursts. Speculation can also lead to excessive trading, which can make the market more volatile and less efficient.

Ultimately, speculative investing can weaken the stock market and the economy by creating instability and preventing long-term growth. “It’s probably fair to say that pretty much every financial crisis since the tulip mania of the 1630s can be attributed to some sort of mass speculation,” writes Professor Lawrence Mitchell, author of Corporate Irresponsibility: America's Newest Export.

Professor Mitchell calls speculative investing an “economic parasite” that “never contributes to a productive economy.” Woof. He might have a point, though. When speculative investors artificially detach the price of an asset from its intrinsic value, it can have disastrous short- and long-term consequences.

  • Pre-2008, when pretty much everyone speculated that mortgage-backed securities like CDOs were infallible (without looking at the radioactive subprime waste inside), we created the world’s worst economic recession since the 1930s.
  • The GameStop craze may have made a few r/wallstreetbets users rich, but naive new traders who bought near its peak share price of $483 are now facing a 68% loss. Plus, regardless of our sympathy, hedge funds Citron Capital and Melvin Capital (and their clients) were victims of a nine-figure short squeeze.
  • Despite the International Monetary Fund urging him not to, President Nayib Bukele of El Salvador has spent $100 million of his taxpayer’s money purchasing Bitcoin. His investment is now worth half of its original value. And while he technically hasn’t lost anything until he sells, his speculative actions have led to plummeting credit ratings and expectations of default.

Indeed, speculative investing can go very, very wrong for the investor or the economy as a whole.

Why the stock market & economy actually needs speculators

Despite all of its negatives, speculating can also be a good thing. Not all speculative investors are parasites — some are white blood cells keeping the markets healthy and safe for regular investors.

In fact, many of the blue chips underpinning our mid- and long-term portfolios are only there because some speculator made a risky play to get them off the ground. If Andy Bechtolsheim and Jeff Bezos hadn’t bet $250,000 on a hunch in 1998, we might not have Google giving us a steady 12% APY each year.

To build on that last point, the market needs high-risk speculative investors because they’re often the only ones that’ll take a chance on small- to mid-size companies with lofty goals. ESG and climate-friendly companies that offer a vision — and little else — might find it impossible to get a traditional loan or institutional capital. But once they find the right speculator who shares their vision for a better world, the check is in the mail.

Finally, speculators tend to trade big and trade often.

Like 5W-30 motor oil, speculators’ fast and frequent moves lubricate the markets, improve float, and reduce volatility.

So speculative investing isn’t all bad. Some might even call them unsung heroes doing a dirty job for our benefit — and the occasional personal windfall.

Best ways to hedge your risk while speculating

You're not missing out if you don’t dabble in speculative investing. To achieve financial independence, you don’t need crypto, Beanie Babies, or a 10% stake in a promising startup.

All you need is a diversified portfolio of “boring” investments like bondsBlue ChipsETFs, and index fundsCompound interest and patience are your greatest allies.

But speculative investments can be exciting and profitable and rapidly expand your knowledge of the markets.

The potential downside, of course, is losing money. So let’s talk about the two best ways to protect yourself from incurring crippling losses while speculating.

Paper trading

The best way to indulge in the thrill of speculative investing — with absolutely zero risk to you or your financial goals — is to paper trade.

This feature on many modern brokerage apps lets you trade using fake money. You can build a hypothetical portfolio, lose it all in a month, and completely start over with no real downside.

This “sandbox” approach can scratch the itch for aspiring speculators without any risk exposure. Plus, it all still feels surprisingly real. And while the money is fake, the knowledge and experience you gain carry over to your other investments.

More: Paper trading: Experience investing without any actual risk

Start a 5% “YOLO” fund

One of the most straightforward ways to hedge your risk is to limit your exposure. I never invest more than 5% of my overall portfolio in speculative investments. I call it my “YOLO fund,” and it’s made up of capital that I’m OK with losing.

At present, my YOLO fund is mostly full of crypto, and it is now beating my main fund by 5x, even in the Crypto Winter. However, I won’t invest a penny more than 5% in my YOLO fund or a penny more in crypto because I know how transient these gains are.

That’s why I recommend you start a dedicated speculative investing fund with no more than 5% of your overall investable capital, depending on your risk tolerance. That way, you can earn some nice gains without risking delays to your regular investing goals.

The bottom line

Speculative investing is like fire — it's necessary but dangerous. In a controlled environment, it can sustain life; but in the hands of amateurs, it can be incredibly destructive.

If you wield it yourself, do so with caution. Keep the ember small.

Further reading:

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Chris Butsch Freelance Contributor

Chris helps young people prosper - both mentally and financially. In addition to publishing personal finance advice for Investor Junkie (now Moneywise) and Money Under 30, Chris speaks on the topics of positive psychology and leadership through CAMPUSPEAK and sits on the advisory board of the Blockchain Chamber of Commerce.

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