Speculative stocks are always a risk, understanding the nature of those risks is key

In the 18th century, pioneering economist Adam Smith said that the public tends to overvalue “speculative ventures”. We think this makes excellent investing advice for present day investors in speculative stocks.

When a speculative stock is losing money, it has a great deal of freedom to ponder on its future. With a little imagination, it can always show that anything’s possible, based on a logical series of events that it says will take place as it advances inevitably toward profitability. Meanwhile, it doesn’t need to worry that its price-to-earnings or p/e ratio is too high, since it doesn’t have one—it has no “e”.

When a former money-loser finally starts making money, however, the handcuffs go on. Suddenly this speculative stock has a p/e, probably one that is sky-high. Inevitably the killjoys (like us) then start calculating how fast it needs to grow to justify its current stock price, let alone go higher.

Meanwhile, the company’s management has to look at dull, non-uplifting matters like production, costs and deliveries, rather than ramble on about how wonderful things will be in a few years. Then too, once a company becomes profitable, it faces a new risk: the unexpected earnings downturn.

Of course, we do sometimes recommend stocks that have not yet begun making money, mainly in our advisory for more aggressive investing, Stock Pickers Digest. As long-time readers know, we have had some standout successes, including speculative stocks taken over at a rich premium.

Trying to sell before the death spiral goes too far

Looking at things more generally, however, you need to recognize that the odds are against you when you invest in companies that are not yet making money. Some if not many of these companies will never make any money.

When investors come to realize that a money-loser they own is unlikely to advance into the ranks of the profitable, they generally sell in a hurry. When that happens, the price of the abandoned stock can drop way faster than that of a money-maker that is simply having a bad quarter or two. The drop in the money-losing stock is also much more likely to be permanent.

This drop in speculative stocks is always a bigger risk when the markets are volatile and investors are skittish. Their readiness to sell can set off a death spiral in speculative stocks that have been around for a few years but have failed to achieve profitability.

Under those circumstances, it is probably best to sell disappointing speculative stocks before the spiral has gone too far.

Four speculative stock investing tips:

1. Limit speculative holdings to 30% of your overall portfolio. Because aggressive stocks expose you to a greater risk of loss, we recommend limiting your aggressive holdings to no more than about 30% of your overall portfolio. That number can vary. Ultimately, the percentage of your portfolio that you should hold in either conservative or aggressive investments depends on your personal circumstances and risk tolerance. An investor with a longer time horizon or without the need for current income from a portfolio can invest more money in aggressive stocks. But we think 30% is a good rule of thumb.
2. Focus on investment quality when looking for aggressive stocks with the potential for higher returns. When we look for aggressive investments, we zero in on companies that have established a business and have at least some history of building revenue and cash flow. We also look for companies that stand to benefit as the economy continues to improve, and have proven management and long-term growth plans. That’s very different from so so-called concept stocks, many of which are start-ups or companies that look to profit from next week’s or next year’s investor fad. These companies can generate big returns in a good year. In the long run, though, they are likely to cost you money.
3. Diversify your aggressive investments: As with your more conservative holdings, we recommend that you cut your risk by spreading your aggressive holdings across the five main economic sectors (Manufacturing & Industry; Resources; Consumer; Finance; and Utilities). Your emphasis may diverge. In the search for greater gains, you may choose to invest more heavily in Manufacturing and Resources, the two riskiest sectors. If so, take care to spread your money out across the many industries within each of these sectors. That way, you protect yourself from an unforeseeable industry downturn.
4. Downplay speculative stocks in the broker/media limelight: That limelight fosters bloated investor expectations. Stocks that are talked up like this may seem like ideal candidates for big gains, with lots of investors getting on board. But when stocks fail to live up to those expectations, brutal downturns follow. Applying that aspect of our conservative philosophy to an aggressive portfolio leads us to stay out of most new issues. That’s because most new issues come to market when it’s a good time for the company or insiders to sell. That’s rarely a good time for you to buy.

Have you ever had success with a speculative stock that was not making money when you bought it? Have you ever had to take a loss with a speculative stock? Would you ever buy the stock of a company that was losing money again? Let us know what you think in the comments section below.

Note: This article was originally published in 2012 and has been updated.