Speculation and Risk…Bad for You?
To some, the term “speculative stock” carries a negative connotation.
In fairness though, when you buy any stock, you are speculating to some degree. You buy a stock because you think it will go up in price, but there is no guarantee that will happen. In fact, the price could go down and you would lose money.
But in the investing world, when we say stock is speculative, usually we specifically mean that the investment carries very high risks.
Here again, we encounter another term with negative connotation.
Risk Does Not Equal Loss
An investment with high risk simply means there is a wide range of expected outcomes, both good and bad. Risk itself doesn’t mean losing money. There’s just more volatility.
By contrast, something with low risk has a narrower range of expected outcomes, so you are more confident what your actual return will be.
The downside to always going with low-risk investments is that over time you probably won’t earn a lot of return for your money. In fact, when inflation is high (as it is now), your real return (adjusted for inflation) could be negative.
Consider Risk Tolerance
The key is to achieve a balance where you take on some risk to increase potential return, while not taking too much risk where too many stocks could end up with big negative returns and ruin your overall portfolio.
For this reason, it makes sense to have a mix of lower-risk stocks and higher-risk stocks. How an investor allocates his or her money between the two groups would depend on risk tolerance and individual situation.
For example, someone in retirement who has a good amount of savings but little new income should view capital preservation (not losing money) as a top priority and not take many risks. On the other hand, a 40-year-old expecting to work at least another 20 years can afford to take some risks to try to build up a big nest egg.
And this takes us back to speculative stocks. They could give you multi-fold returns if things go right. However, if things go wrong, these stocks could fall a lot, possibly even to zero.
All or Nothing
Some examples of speculative stocks would be the shares of junior miners, startup biotech companies, and marijuana companies.
Junior miners own mining assets that are still in various stages of developmental. If a junior miner can successfully bring an attractive mine to production, the company can make a lot of money, but along the way there are many potential pitfalls. For example, the company could fail to obtain permits or it could run out of money.
Similarly, a startup biotech company is working on different drugs. If it succeeds to bringing a significant drug to market, the value of the company is going to greatly increase. However, if a drug candidate fails in clinical trials, then the value of the company can take a huge hit, depending on how important to the company’s fortunes the drug is.
As for marijuana companies, the marijuana industry has a huge growth runway. However, questions remain regarding the future of regulation and many companies are vying for a piece of the pie. The size of the pie is vast though, so betting on the right company can be a very profitable endeavor.
Rule of Thumb
No matter what industry you prefer though, it’s unwise to risk everything in speculative stocks.
A good rule of thumb is to not risk any money you can’t afford to lose in speculative investments. The obvious reason is that you will be in financial trouble if you lose the money, but there’s also a less obvious reason. If you put money you can’t afford to lose in a volatile stock, you are more likely to be emotionally affected by the stock’s movements, potentially leading to a trading decision you will regret later.
Fifty years of wealth-building…
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Personal Finance, founded in 1974, is our flagship publication and it has helped investors build wealth for nearly 50 years.
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