Speculation is perhaps more prevalent today than ever before. Crypto, NFTs, collectibles, meme stocks, even sports gambling - no matter the speculative endeavor of choice, more people are taking more risk with their hard earned money. But make no mistake, speculation is hardly a “new” fad. In fact, the history of speculation dates back many centuries.
Be that as it may, engaging in speculation today is inarguably the easiest it’s been in history, with countless avenues for monetary risk available at a few taps of the finger on smartphones. The link between speculation and entertainment is at its strongest as a result. So, what should you know about speculation before embarking down one of these paths?
Speculation is the participation in a financial transaction - in most cases, the purchase of an asset - with the expectation of financial gain, but with substantial risk of losing all of the capital involved. It’s the second part of that statement - the risk - that crucially characterizes speculation. Speculative investments are generally less reliant on fundamental factors and analysis and more dependent on uncontrollable forces, chance, and market psychology. Put another way, the value of a speculative investment is often based less on underlying cash flows and output and instead more on supply & demand, investor sentiment, and the popularity of certain tastes and trends.
Those factors are far more difficult to measure, predict, and control, thus introducing a substantial degree of risk. When those factors turn against you, the downside can be devastating. This is particularly the case in the absence of underlying fundamentals and cash flows, which render selling below a certain level irrational, thus limiting losses.
The primary difference between investing and speculating is the amount of risk taken in deploying capital. While the risk in speculation is quite high, meaning there is a significant chance of total or near-total loss of principal, investing is generally done with the goal of optimizing the balance of expected return and risk, with lower risk of losing one’s entire principal. Investments are generally made on assets with either a history of producing cash flows (which provide clear value to the investor) or a track record of output and a calculable likelihood that output can later lead to profits for the investor.
FOMO, or the fear of missing out, plays a significant role in perpetuating speculative activity. When speculative markets heat up, those winning in the space are generally quick to advertise their gains or newfound riches. These boasts capture the attention of those not yet in the market, who fear they’re missing out on similar opportunities to build wealth quickly.
Motivated by that fear, those individuals enter the market, purchasing assets with the expectation that they’ll experience the same appreciation. When that happens on a wide enough scale, the entrance of new parties to a market will drive market values higher with buying activity. Conveniently, the participants on the other side of that buying activity are the earlier entrants, who are now provided an exit opportunity to crystallize their gains.
In many cases, those motivated by FOMO will not do the requisite research to understand the assets and markets they’re buying into, instead relying on those success stories as sufficient evidence of merit. If you’ve heard the phrase “apeing in”, that’s essentially what we’re describing here. These new market participants may lack an understanding of risks and market drivers, therefore missing signs that a market is approaching peril. When it eventually turns, it’s those participants left holding the bag, experiencing significant losses as a result.
Collectible assets are most typically considered speculative investments. As mentioned above, the values of speculative investments are often driven predominantly by factors like supply & demand, investor sentiment, and the popularity of certain trends. Those are effectively the precise factors driving the value of collectible assets. Perhaps more importantly, collectible assets are categorized as speculative based on what the vast majority of them don’t produce: cash flow. For most collectibles, there is no underlying economic output. Investors in collectibles don’t earn dividends or clip coupons, and they can’t point to improving underlying revenue and profitability trends that would make those things possible in the future.
Instead, at its core, the value of a collectible is most often driven by how much of that asset exists in the market and how many people want that asset. The prevailing market sentiment in a given moment can make the latter fluctuate up or down, and it can also impact the magnitude of their willingness to pay. When times are good and values are in the ascendancy, people are more likely to pursue speculative assets, and the amount that they’re willing to pay for them - with the expectation that they’ll continue to go up - also rises. When economic conditions worsen and people are less excited about the state of the economy and more nervous about their personal financial standing, the opposite happens. For many collectibles, there’s no real hard, quantifiable limit to just how far values can fall (with the exception of to zero), because there is no utility, no underlying economic output.
It’s important to note, though, that highly traditional financial instruments can be incredibly speculative as well. Equities can be very speculative - just look at the Gamestop saga and the money that flowed into and out of AMC. At certain levels, even buying well known and successful companies like Tesla can be considered very speculative. When stocks are trading at astronomically high multiples versus their earnings or, worse, their revenues, there is considerable risk involved, and activity in those stocks can lean far more speculative in nature. Even bonds, which many would consider boring, can be speculative. For example, bonds can be purchased for pennies on the dollar on the basis of a speculative belief that distress won’t turn out to be as grave as originally thought.
So, it’s really less the vehicle used that defines speculative vs. investment activity, but rather the thought process, the expectations around drivers of value, and the corresponding level of risk.
This is perhaps a matter of opinion, but the multitude of individuals, funds, and businesses that have enjoyed repeated success stories in certain speculative markets suggests that not all speculation is uneducated. It’s possible to speculate smartly on the basis of an educated thesis: an investor can lay out a credible case for why demand for an asset or asset class might increase, or why supply and demand are actually imbalanced but the market hasn’t realized it yet.
It’s not uncommon that market participants are able to speculate successfully, armed by robust data, an ability to forecast trends, and a strong understanding of investor psychology and sentiment. It’s logical - if wealth was never accumulated in these markets, they would not rise to prominence in the first place.
The challenge, though, is that investors can develop well-conceived investment theses that are ultimately never validated by the whims of the market and instead lead to significant losses when things don’t play out. In less speculative arenas, it’s more often the case that an investment thesis will revolve around improved business prospects (stronger revenue growth, higher margins, a larger dividend, greater creditworthiness) that eventually work their way into the prevailing market thought around an asset. That’s a core difference: even when speculation is well-educated and savvy, the risk (in theory) can still be very, very large.
We’ve detailed the high degree of risk that is generally commensurate with speculation. Given that high risk, it’s important to discuss risk tolerance in the context of speculative investments. Risk tolerance is the level of risk that a given investor is willing to tolerate or endure to achieve certain results.
It’s often the case that, in order to achieve significant gains, an investor needs to embrace a higher level of risk - the potentially large gains are the reward for embracing that risk. Put another way, an investment in a large, stable corporation that doesn’t fluctuate in price very much is considered a relatively low risk investment. But, because it’s low risk and stable, an investor wouldn’t expect the same high-flying returns possible in growth stocks, where the array of outcomes is much wider.
An investor with a very high risk tolerance is willing to lose a lot of money in the pursuit of higher returns. They can stomach those losses. Typically, high risk tolerance investors are earlier on in their lives or careers, have steady income to replace losses, and don’t require their principal for retirement or other large expenses in the near future. On the flip side, low risk tolerance investors may be in the late stages of their earning years, preparing for retirement, and really can’t afford to have a large hit to their portfolios.
Now, these are just examples of people that might gravitate towards a certain risk tolerance, but in practice, it can be quite personal. However, it’s most important that an investor understand the magnitude of loss possible with any investment, and that they truly consider their capacity to endure that investment going to zero.
This is where it becomes critically important to understand one’s risk tolerance. The lower one’s risk tolerance, the lower the allocation to speculative assets should be. That way, if the worst outcome does occur, and the speculative assets do become worthless, it affects only a very small percentage of an individual’s overall portfolio. A 100% loss on 1% of the portfolio still leaves you 99% intact. That’s not a suggestion that 1% is the “right” number, but it does illustrate how a conservative tact can spare investors from considerable stress.
If an individual has a higher risk tolerance, they might pursue a more aggressive allocation to speculative assets, particularly if they feel they have an informational edge or a very well conceived investment thesis. Even if that is the case, though, it’s generally ill-advised to pursue truly outsized allocations to speculative investment plays, even if they’re spread amongst different categories. Why? Well, as we saw at the beginning of the summer of 2022, it’s not uncommon for speculative assets of wide variety to suffer at the same time. Crypto, stocks, collectibles - all suffered considerably. An investor significantly exposed to these assets would’ve been looking at a significantly battered net worth, margin calls (though leverage is another topic for another day), and maybe even an inability to meet certain liabilities or liquidate assets to cover unforeseen expenses. The regret arising from that situation is likely to be far worse than the FOMO that might’ve inspired the large allocation.
For most individuals (and this is not investment advice), an allocation to speculative assets will not make up more than 5% of a portfolio, and they might thank themselves for keeping it that low in times of distress, even if FOMO makes it seem foolhardy in brighter moments.
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