Barbara Friedberg* says speculative investments promise higher returns than typical stocks and bonds, but they are also much riskier.
Photo: Gino Crescoli
With the popularity of bitcoin, cryptocurrency, crowdfunding and peer-to-peer lending, investing has gone from just stocks and bonds to vast investment choices.
With the promise of massive returns, I’ve been thinking about what percentage of an investor’s portfolio should be allocated to speculative stocks, bonds, crypto, crowdfunding and more.
What are speculative investments?
Financial speculation promises higher returns in exchange for higher risks.
When shooting for sky high investment returns, like more than 10 per cent annually, be prepared for the possibility of losing all or a majority of your investment.
Speculative trades include investments such as:
- Cryptocurrency
- Initial public offerings (IPOs)
- Crowdfunding
- Peer-to-peer lending
- Foreign exchange
- Derivative or hedging strategies
- High yield bonds and bond funds.
What is the difference between speculation and investing?
Investing versus speculating involves risk and probabilities.
The stock market has yielded an average return of north of 9 per cent over decades and bonds averaged approximately 5 per cent.
Investing in a diversified portfolio of stocks and bonds for long term profits is considered investing.
Investing typically yields positive long-term returns and offers a reasonable possibility of loss.
Some investments offer dividends or cash flow, to cushion any declines in the investment’s value.
Speculative investments promise higher returns than typical stocks and bonds and are riskier.
The investor must be willing to lose a large portion of their initial investment, in exchange for the possibility of outsized returns.
How much of your portfolio should be speculative?
Whether you’re a risk-seeking aggressive investor or a conservative type, you might want to allocate some portion of your portfolio to speculative investments.
The only criteria for a speculative investor is the willingness to risk losing.
That means if you’re near retirement, or have a limited portfolio, you probably don’t want to speculate.
It’s helpful to understand your probability of making a killing with speculative investments.
Hint — it’s lower than you might think.
Mark Hulbert, creator of the Hulbert Financial Digest, reported that during the last two market cycles, the 20 best market timers reduced portfolio volatility by 25 per cent.
But, had these same investors just bought and held a portfolio invested 80 per cent in stocks and 20 per cent in bonds, they would have earned a higher return with equivalent risk as the market timers.
Before considering what percentage to invest in speculative investments, figure out your risk tolerance.
If you can’t tolerate big investment losses, you probably shouldn’t consider speculative investments.
Your chances of long-term success are very low.
These days you will be competing against complicated computer programs, which have no emotions with which to contend.
In most cases, the machines are going to win over the individual traders.
So, here’s an alternative if you want to try your luck with speculative investments or an active trading strategy — put a small part of your investments in speculative assets like bitcoin or individual stocks.
Speculative investments: My secrets
I invested in a limited partnership for a private airplane rental company and received a 12 per cent dividend payment.
The investment was required by law to pay out all earnings in dividends.
Sounds great doesn’t it?
It was wonderful, until the price of the limited partnership ultimately dropped 75 per cent.
I didn’t actually lose money on that investment since, over time, I recouped more than my original investment in dividends.
But that investment demonstrates what can happen when you reach for the dividend sky.
At present, I invest in peer-to-peer lending.
I have a small percentage of our total net worth invested in this risky asset class.
With defaults mounting and returns plummeting, I’m transitioning away from peer-to-peer lending.
I haven’t tried bitcoin or any of the crowd funding real estate platforms yet, but I continue to think about them.
What percentage to invest in speculative assets depends upon the size of your portfolio, your age, and your risk tolerance.
What is your risk tolerance?
First, ask yourself how you will feel if you lose 100 per cent of your speculative investment, which is possible.
Bitcoin was trading at $9,000 late last month.
If you bought on 25 June, at $12,643, you’d have lost 25 per cent of your investment in two months!
Use your response to that question to guide your speculative asset investment decision.
If you don’t mind risk and can still sleep if your portfolio makes a double-digit fall, consider a maximum of 10 per cent in speculative assets or individual stocks.
It also helps if you are younger than age 40 when choosing speculative trading.
If you’re younger, you have many years of earnings to make up your losses.
For most individuals, I wouldn’t suggest investing more than 5 per cent of your net worth in risky assets.
If you have a growing portfolio and you lose all of your money in your speculative investment, a 5 per cent loss shouldn’t ruin you.
And if you can’t afford to lose most or all of the speculative investment, then go back to a more conservative asset allocation.
Obviously, if you have a large investment portfolio, then you can invest as much as you can afford to lose in speculative investments.
If you’re young, have a good steady job and a desire for big profits, go on and reach for the stars.
Just be prepared for a rocky road and possible losses.
* Barbara Friedberg is an investment and wealth-building expert. She tweets at @barbfriedberg.
This article first appeared at barbarafriedbergpersonalfinance.com.
