There’s a constant temptation to speculate on high risk investments that offer the potential for massive returns. Unfortunately they also offer a high chance of catastrophic loss. Should you ever be tempted to speculate with a portion of your money? And if you do, what are the ground rules to improve your chances?
Years ago – perhaps 15 years – I was in Zurich and chatting with a senior Swiss private banker at my old employer UBS Group, the huge wealth manager and investment bank.
He told me that there was a particular group of clients that tended to lose a lot of money in their private accounts. Namely the professional traders that worked for investment banks and hedge funds.
His explanation was that they were overconfident in their own abilities. Freed from the risk control shackles imposed on them at work, this led them to make large speculative bets in their private accounts – often outside of their specialist areas of expertise. According to the private banker the results were, more often than not, dreadful.
“I definitely don’t have the stomach for this wild roller coaster. However, what’s wrong with taking 5% of your portfolio and playing the speculation game? Maybe you can get lucky, like Bitcoin eight years ago or buying the next Amazon or Google.”
George T., California, USA.
Thanks to George for the question. Before I try to answer, first let’s make sure we’re clear what we’re talking about here.
According to the Oxford English Dictionary, this is the definition of something “speculative”: 1. engaged in, expressing, or based on conjecture rather than knowledge. 2. (of an investment) involving a high risk of loss.
In other words, when we talk about “speculation” or “speculative investments” we’re talking about staking money on things with highly uncertain prospects. It’s like betting on outsiders at the horse races. Most of the time you’ll lose your stake. Once in a blue moon you’ll have a big win.
The kind of venture capitalists that invest in technology startups understand this dynamic. If they invest in 10 to 20 new companies they’ll be lucky if only 1 or 2 are massive successes. Some may do modestly well, but most are expected to fail.
Should you speculate?
The implication is that you need to spread your bets if you’re playing the high risk speculation game. That “5%” allocation had better be split across plenty of different things if you want a decent chance of keeping it, let alone making a profit.
If you have the time and inclination to identify and track 10 or more speculative bets then, by all means, give it a go. But it’s likely to be a lot of work for little likely reward, relatively speaking, as the many losers offset the few big winners. And you’ve still got your less speculative 95% of core investments to keep an eye on as well.
It also means that you don’t need to worry if you’re not inclined to high risk speculation. Chances are that you’re not losing out, at least in terms of net gains.
In this context it’s extremely important to remember this simple truth: people often brag about their big winners, but hardly ever mention their catastrophic losers.
What this means it that there’s a lack of symmetry in the investment tittle tattle that’s likely to make you think you’re missing out. In reality you probably aren’t.
In any case, if you are speculating with a piece of your wealth then it’s essential it’s diversified. If you punt 5% on one risky thing at a time, and the first 10 punts in a row don’t work out, you’ll have quickly burnt through half your original funds (okay, less if you limit yourself to 5% of what’s left each time). I don’t think anyone would want that.
Some thoughts on speculative stocks
What about stocks? Of course there are 100 plus baggers out there. But catching them early…not to mention hanging on for the ride…is hugely difficult. Let me illustrate that last point.
Say you put 1% of your wealth into a speculative stock. It turns out to be a massive success. Perhaps of the magnitude of Apple Inc. (NASDAQ:AAPL) stock since the first iPod was released in 2001…which in turn was well before the 2007 release of the original iPhone, the company’s current core product. (The less said about Apple stock’s preceding 20 years the better.)
Let’s say this speculative stock goes up 100 times over 15 years, while the rest of your portfolio goes up 2 times (about 4.7% a year after tax). If you held on, your position in this one stock would end up being just over one third of your entire portfolio (100 parts in 298).
Does anyone really want to have a third of their retirement fund riding on one company? I suspect most people would (sensibly) trim their position along the way, which of course would mean a smaller overall profit.
But how can you spot such winners in the first place? As I mentioned before, Apple stock was a bit of a dog before the early 2000s, except for a brief spell during the late ‘90s tech bubble. The iPod was a great innovation, but investors at the time couldn’t possibly have predicted the subsequent invention, runaway success, fashionability or premium pricing of the later iPhone(s).
And while we’re at it, let’s not forget the deaths of previous darlings of the mobile phone business: Nokia Oyj (NYSE:NOK) and Blackberry Ltd (NASDAQ:BBRY). They each had their moment in the sun, and then imploded as something better came along. But that’s a story for another day…
Alphabet Inc. (NASDAQ:GOOG) – owner of the Google search engine and also a venture capital company these days – is another runaway success. Given its dominance today it’s easy to forget that the leaders of internet search were once completely different. Think of AOL, Yahoo and countless other search engines that folded along the way.
Picking the eventual winner back in the late 1990s or early 2000s was no picnic. In other words it was highly speculative.
How about Amazon Inc. (NASDAQ:AMZN), online bookseller turned webpage-cum-logistics-cum-delivery company? Its market capitalisation is now an incredible $482 billion despite barely making a profit. (It’s the “river of no returns”, as my friend Bill Bonner refers to it.)
Obviously the stock has been a hugely successful result for early speculators. As Winston Churchill might have put it: Never in the field of human investment was so much gained by so many from so little.
Currently Amazon stock has a price-to-earnings (P/E) ratio of 191 and price-to-sales (P/S) stands at 3.4. The company has been (legally) inflating cash flows in recent years by extending the time to pay suppliers. Once you adjust for that – since it can’t go on forever – I estimate that normalised free cash flow is somewhere around $6.5 billion. Put another way, the stock trades with a price-to-free cash flow (P/FCF) ratio of about 74.
By any valuation measure Amazon remains a speculative bet. It needs massive growth and/or a thus far elusive increase in profit margins for investors to come out smiling. By which I mean for the company to be in a position to eventually make cash distributions. You know, that thing that ultimately makes all stocks worth owning.
(Also it’s interesting that Amazon’s asset depreciation charges have been running higher than capital expenditure for the past two years. So it doesn’t look as if the company can suddenly slow growth, slash capex and create a cash gushing miracle. Assets need maintenance and replacement.)
Speculation can be fun and exciting if you’ve got the time and the inclination to do it. But if you haven’t then you probably aren’t missing out. Ultimately the choice is a question of personal preference. Just remember not to get carried away, unlike those over confident professional traders that I was warned about all those years ago.
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