I recently read an interesting definition of speculation by Robinhood investors.
Speculation is when investors put their money toward something that is often a long shot, but that could potentially earn them a lot of money. The analogy explained that speculation is like investing all your money into a plot of land because you think you will find gold. If it really does have gold, your investment will have a phenomenal pay off. But if the plot of land has nothing but weeds and grass, you are staring at a huge loss.
What it does not say is that the speculator bought the land based on a rumour or a tip. On the other hand, an investor would have considered geologic indications pointing towards potential gold deposits, and would have also studied the government regulations and environmental clearances. Only then would she consider parting with her money as her investment would now be backed with research, making the odds of a return much better. That hints at the difference between investing and speculating.
Speculation is a cocktail of a few ingredients.
- Psychological: The feverish attempt to make money by getting lucky. Speculators have a short-term outlook – they want to make money and make it fast.
- Hope: Buying something in the hope that its value will increase and then selling at a higher price to make a profit.
- Probability: Guessing possible outcomes with insufficient information to be certain about any.
- Nature of the payoff: The investment carries a high likelihood of loss, but also the likelihood of exponential profit.
I think we can go with how Warren Buffett defined speculation 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.
How to have peace of mind when you speculate.
Speculation may be a dirty word, but it is neither illegal, nor immoral. There is nothing wrong in ethically taking advantage of an opportunity. But very few speculative bets win, and therein lies the rub. It will be foolhardy to speculate with a sense of entitlement. There is no fairness or equality in the speculative process. So play it smart.
Have you ever heard of the term “mad money”?
Did you know that it originally referred to money a woman carried with her on a date? In case it ended on a sour note or in a misunderstanding, and the lady was forced to walk away and reach home on her own, this money would be handy for a cab.
The conventional definition of mad money is a small sum of cash kept in reserve for impulse purchases. Use that for your speculative purchases. Am I encouraging speculation? Not at all. However, we are human. And when we get that tip, the temptation of quick and large financial gains is difficult to resist. Instead of selling some of your investments to dabble in the unknown, be prepared.
Speculation is a slippery slope, so here are 6 speed breakers to put into place.
- If you are drowning in debt, you cannot afford to speculate. Hoping to make obscene amounts of money to clear your debt will take you further down the rabbit hole.
- Have a basic portfolio in place. Have your asset allocation (equity-debt) sorted out. If you are invested in mutual funds, ensure that your money is going in via systematic investment plans (SIPs).
- Have an Emergency Fund. Do not ever allow yourself to be in a situation where access to money is woefully limited when you need it the most. And circumstances force you to borrow your way out of trouble when it arises. Have an Emergency Fund of at least six months of basic expenses.
- Speculate only with money you can afford to lose. If you cannot afford to be wrong, do not make the bet. 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 would not take your rent money to Macau, do not put your life savings on the line hoping that the herd will take the price even higher.
- Put a cap in place. A fixed amount beyond which you will not venture. It is very easy to get carried away if you don’t have a pre-determined limit.
- Mentally categorize it as money spent. When you view it that way, the volatility will not get to you. You will be able to view it much more objectively and calmly. And any outcome other than a total loss is an improvement.
This is important.
There is nothing wrong with speculating, but do not conflate it with investing. If you do, you could lose all your money. But by understanding the difference, you can put it in its place without giving it the power to destroy your portfolio.
Larissa Fernand is Senior Editor at Morningstar India. You can follow her on Twitter.