It’s been said that one good speculation is worth a lifetime of prudent investing.
I know this to be true from personal experience.
Three of my investments – each up more than hundredfold – have had a dramatic effect on my long-term returns and total net worth.
How do you identify an investment with the potential to go up severalfold?
There’s a process. I call it “mastering the art of intelligent speculation.”
Let’s start by defining the terms investor, trader and speculator.
Investors measure their returns in years – or decades – and ignore short-term fluctuations. (Typical investment selections include blue chip stocks, index funds and high-grade bonds.)
Traders, on the other hand, measure their returns in weeks or months. They don’t ignore short-term fluctuations. They seek to capitalize on them. (Typical trading vehicles are small cap and midcap stocks, hypergrowth stocks, and other high-beta equities.)
Speculators seek even higher short-term gains and are willing to risk more – potentially the entire investment – to achieve their goals. (This category includes options, futures, penny stocks and cryptocurrencies, for example.)
The three groups are not mutually exclusive, of course. In my experience, the best approach is to be a long-term investor who also trades regularly and speculates occasionally.
Intelligent speculators, in my view, combine the best qualities of each. They are short-term oriented and willing to risk more in the pursuit of much higher-than-average returns – but are also willing to hold longer term if it maximizes profits.
To better understand intelligent speculation, let’s consider four things that it is not…
1. Timing the Market
If part of your speculation is based on a guess about what any market – stocks, bonds, currencies, metals, commodities – is about to do next, it is fundamentally flawed. I am a militant agnostic on this subject. (I don’t know what the market will do next – and neither do you.)
Everything about the future that is known or highly probable is already discounted in stocks by rational, self-interested investors. (That’s why academics call financial markets “efficient.”)
What will move stocks tomorrow or next week is tomorrow’s or next week’s news. We can’t know that now. And betting on the unknowable is gambling, not intelligent speculation.
2. Investing in things you don’t understand
Warren Buffett missed the dramatic run-up in internet stocks two decades ago. He also sidestepped their complete meltdown. Why? Because he didn’t understand them.
In Berkshire Hathaway’s annual report 18 years ago, he said, “We have embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation and paint. Try to control your excitement.”
If you are an expert on cryptocurrencies, blockchain, nano caps, angel investing or arbitrage, go knock yourself out. The rest of us can reasonably pass on these categories.
3. Getting stuck in illiquid securities
You wouldn’t enter a building without clear, easy-to-find and well-marked exits. The same should be true in your portfolio. Always prefer securities that are easy and inexpensive to trade, have plenty of volume (i.e., high liquidity), and have no surrender penalties.
To me, intelligent speculation means giving a pass to hedge funds, annuities, art and collectibles, private equity, venture capital, and options that trade by appointment only.
You should be able to exit any speculation on a moment’s notice and – especially in today’s world of deep-discount brokers – at a cost of no more than a few dollars.
4. Overestimating the potential of low-priced stocks
It may seem reasonable to you – as it appears to be to so many investors – that it is easier for a $5 stock to go to $10 than it is for a $50 stock to go to $100.
I can assure you this is not the case. Plenty of research confirms this. Unfortunately, the same studies also show that it is a whole lot easier for a $5 stock to go to zero than it is for a $50 stock.
I could get into a long, technical explanation of why low-priced stocks do not outperform higher-priced ones, but let the following suffice…
Corporate officers and directors receive much of their compensation in the form of option grants. That means the better the stock performs, the higher their compensation. If a low-priced stock truly outperformed a higher-priced one, wouldn’t they simply split the stock down to a few dollars a share and reap the rewards? They don’t because it wouldn’t.
The share price of a stock tells you nothing about its upside potential.
These are just a few examples of the wrong ways to go about speculating. In my next column, we’ll look at the right ways.
Intelligent speculation is not an oxymoron. And following just a few important principles will dramatically impact your real-world returns.
Thoughts on this article? Leave a comment below.