A friend called me the other day to ask how she can invest in bitcoin. Her rationale was straightforward; the entire world was making money on it, and she did not want to miss out.
My initial question was, “Why on earth are you speculating?” My second question was to retract that with another question to myself: “What exactly is speculation?”
Speculation is a slippery word.
Buying something in the hope that its value will increase and then selling at a higher price in order to make a profit is speculating. Of course, this can even be the definition of investing, the key term that pushes it into speculative territory is hope.
I like the definition offered by Cambridge Dictionary, which views it through the lens of probability: the activity of guessing possible answers to a question without having enough information to be certain.
Maybe we can look at the nature of the payoff: if the investment carries a high likelihood of loss, but exponential profit, then it is speculation. John Rekenthaler, vice president of research at Morningstar, has an example.
A wager that has an 80% chance of losing $100 and a 20% chance of gaining $1,000 is very different from a wager that has an 80% chance of losing $100 and gaining $400, because the former has a positive expected return, while the latter does not. Each involves high risk, with the possibility of a large gain. But those two wagers don’t belong in the same bucket.
The first is an investment. To be sure, it is almost absurdly risky, losing the entire $100 stake four times out of five. However, its average expected return is outstanding, being double the outlay. In contrast, the second wager rates as speculation, because its expected payoff is less than the expenditure. Making that bet is akin to purchasing a lottery ticket; the buyer succeeds by being lucky rather than smart.
Rekenthaler confesses that it is greatly oversimplified. a) It ignores wealth effects. Despite its positive expected payoff, the first wager must be downgraded to speculation for the person who only has $100 to lose. b) It overlooks the benefits of diversification, as repetition makes the first gamble increasingly safer (and the second gamble increasingly more dangerous). c) It doesn’t address the risk-return relationship. Securities with barely positive expected returns and extremely high volatility are speculative--unless their performance is negatively correlated with the rest of one’s portfolio, in which case the investment may be warranted.
I think we can go with what Warren Buffett wrote in his Berkshire Hathaway 2000 shareholder letter. Speculation—in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it.
What are the recent glaring examples of speculation?
- GameStop was heavily shorted by many hedge funds earlier this year, and investors from forums like Reddit decided to bet against the hedge funds, driving up the stock price. The stock moved from $15 in December 2020 to $347 in January 2021. The day after GameStop hit its record high, the price dropped drastically to $193. Two weeks later, the stock was hovering around $50. If you joined the GameStop frenzy at the stock’s high, you could have experienced 85% losses in less than a month. Investors who jumped early on this GameStop train made a fortune.
- Special-purpose acquisition companies, or SPACs, have been around since the 1990s and the structure was historically used selectively by lower-quality firms that would struggle to meet the regulatory requirements for an IPO. This has become a fast-track method for a private company to go public without the lengthy SEC regulatory process for filing an IPO. Michael Corty, head of U.S. equity strategies at Morningstar Investment Management, recently noted that 256 SPACs raised $15.5 billion from investors in 2019, $83 billion in 2020, and as of March 24, 295 SPACs had gone public in 2021, raising $93 billion.
- In March 2016, Bitcoin priced around $400. Five years later, Bitcoin topped $60,000. Much of bitcoin’s eye-popping 10-year record owes to an off-the-charts runup from 2011 through 2013, when the CMBI Bitcoin TR index posted annualized returns of more than 1,000% per year, including a gain of more than 5,300% in 2013 alone. After dropping about 74% in 2018, the digital currency nearly doubled in price in 2019, and then nearly quadrupled during 2020. This kind of volatility, as was pointed out by Morningstar’s portfolio strategist Amy Arnott, can create a fortune if you get the timing right. But if you don’t, it can backfire with a disastrous impact on your portfolio.
You can also speculate on stocks. But the question is, should you speculate?
Why not? It is not illegal, neither is it immoral. If you have “mad money”, please go right ahead.
The conventional definition of mad money is a small sum of cash kept in reserve for impulse purchases. It also refers to the money a woman carries with her on a date, in case it ends on a sour note or in a misunderstanding, and she needs to reach home on her own.
Extend it to investing. Allocate a small portfolio of your portfolio to invest in speculative, but potentially high-returning investments. The temptation of quick and large financial gains is difficult to resist, and mad money can possibly scratch this itch. It helps you step out of your comfort zone and be more adventurous.
There are a few conditions to making mad money work for you. The first being that you already have a basic portfolio in place. The second being that you refrain from going overboard. We suggest limiting your portfolio’s mad money investments to only 5%, so that you do not jeopardise your long-term goals with speculation. The third being that this is money you can afford to lose.
Morningstar’s director of behavioural science Sarah Newcomb encapsulates it brilliantly.
Speculation is fun. It's why a lot of people love investing. So speculate only with money you can afford to lose.
If you are considering putting money on the line that you need for your present or future security: stop, breathe, and walk away. Just like you wouldn't take your rent money to Las Vegas, don't put your life savings on the line trying to guess what the herd will do next.
If you can't afford to be wrong, don't make the bet. And certainly not with money you cannot afford to lose.
