There has been a lot of excitement in financial news recently that can elicit the desire to participate in speculative trading.
GameStop (GME), a company that was trading below $5 a share in the summer, has seen its price rise as high as $483 in January driven by a herd of individual investors pumping up the stock through social media. And then there’s Bitcoin. The mysterious crypto currency, that if you ask most people what it is, they haven’t a clue. Yet its price has gone from about $10,000 in October to over $50,000 this month.
There are always opportunities for speculation. Maybe it’s a highly anticipated initial public offering (IPO) from a popular company, or a hot stock tip from a co-worker. Whatever the opportunity is, you need to assess if it’s the right thing to put your money into. And you need to determine first, are you investing, or speculating?
Investing vs. Speculation
There are many different definitions of speculation. Generally, speculation is engaging in a financial transaction that has a considerable risk of losing its value with the hope of significant and above average return. Short-term trading, market timing, and holding a concentrated position in one stock are all examples of speculation.
Investing involves less risk of your principal investment with the expectation of satisfactory or average returns. Investing takes into consideration a long-term time horizon, having the right asset allocation, a diversified portfolio, and an understanding of the fundamentals of the investment(s).
Rules for Speculation
There is nothing wrong with speculation. It is a way to make money though it involves significant risk. And if you are going to speculate, I recommend following these rules.
1. Only speculate with money you are prepared to lose.
Don’t speculate with money earmarked for important financial goals.
Anytime you invest, you are at risk of losing your money, but the risk is much greater if you are speculating. Money for your short-term goals, such as down payment for a house or a car should remain in safe investments like a savings account, CDs, or a money market. Money for your long-term goals such as retirement should be put in a diversified portfolio of stocks and bonds, preferably mutual funds or ETFs that will be held for the long term. No short-term trading should be done with this money.
2. Make sure you don’t have any debt.
Any money you want to speculate with should be put toward paying off your outstanding debt, e.g. credit cards, student loans, and car loans. And If you are in debt, don’t try to speculate your way out of it.
3. Don’t borrow money to speculate.
The fear of missing out may tempt you to take a cash advance on your credit card, a line of credit against your home, or another source. But if you use borrowed funds to speculate, you are not only at risk of losing your investment, you may end up with debt you can’t pay back.
4. Don’t use margin.
In a brokerage account, you have the option to buy certain stocks on margin. When you use margin, you’re paying for part of the purchase with borrowed money. The benefit is leverage. You get to purchase more shares than if you paid with cash only. But the danger is if the value of the investment goes down.
When buying on margin, you’re required to maintain a certain amount of equity in the account. If the value of your stock goes down too far, you can expect a margin call. This means you’ll need to add more money to the account or be forced to sell a portion of your investment at a loss. If things go really bad, you could end up with a negative balance in your account and owe your brokerage company money.
So when the financial news gets exciting, don’t let your emotions lead you to make a decision that can set you back financially. Remember the risks associated with speculation.
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