What it means
Speculative stocks are usually small, young or in fast-changing industries, such as biotechnology, mining exploration or emerging technology. Their prices move on news, rumours and expectations rather than on steady earnings.
They tend to have high volatility, meaning their prices swing widely over short periods. A rise of 30% in a week can be followed by a fall of 40% the next month, which makes them unsuitable for money that is needed soon.
Investors with short time horizons should look elsewhere. Many are also thinly traded, so a large sale can push the price down and it can be hard to exit quickly.
This is called liquidity risk, and it matters most when markets are falling. Spreads between buying and selling prices can be wide, which adds to the cost of trading.
Careful investors limit how much they hold, usually keeping speculative stocks to a small slice of a portfolio. They also set a plan in advance, including the price at which they will sell if the idea fails.
A useful tool is the reward-to-risk ratio, which compares the potential gain with the potential loss before buying. It helps an investor decide whether the odds justify the risk.
A common rule of thumb is to look for a ratio of at least 2 to 1 before buying. Do not confuse a speculative stock with a growth stock from an established business.
Growth stocks usually have real profits and a track record, while speculative ones rely mainly on future promise.
In practice
Real-world examples.
Example
A trader buys shares in a small mining company that has just started drilling. If the first hole finds a rich deposit, the price may triple, but if it finds nothing, the shares could fall by 70%. He sizes the position so that a 70% fall is acceptable.
Example
A retired engineer sets aside $5,000 of a $200,000 portfolio for a tiny biotechnology firm. If the drug fails, he loses 2.5% of his total savings, while a success could add substantially to his returns. He reviews the holding every quarter.
Example
A private bank adviser warns a client against putting a quarter of her savings into a newly listed electric vehicle start-up. She suggests limiting the position to 3% and setting a sell price in advance. The adviser records the warning in the client file.
Formula
Calculation
Reward-to-risk ratio = (target price - entry price) / (entry price - stop price)
Breakeven success rate = risk / (risk + reward)
An investor buys a speculative stock at $5.00, with a target of $9.00 and a stop-loss at $4.00. Reward = 9.00 - 5.00 = $4.00 and risk = 5.00 - 4.00 = $1.00, so the ratio is 4 to 1. The breakeven success rate is 1 / (1 + 4) = 20%, meaning the investor needs to be right more than one time in five to come out ahead, ignoring costs.Case study
Seen in the real world.
Orbitel Systems is an illustrative, fictional satellite communications start-up listed on a small exchange. It had no profits, spent heavily on launching satellites and traded at $2.00 a share. Its filings warned that a launch failure could end the business.
An investor bought 5,000 shares for $10,000, which was 2% of her portfolio. When the first launch succeeded, the price rose to $4.50, but when the second launch failed, it fell to $0.80.
The illustrative investor had planned to sell if the price dropped to $1.40, and she sold there for a loss of 0.60 x 5,000 = $3,000. Because the position was small, the loss was 0.6% of her portfolio, whereas a larger bet could have done serious damage. She wrote down what she had learned and set a new, lower limit for similar ideas.
Watch out
Common mistakes.
- Buying based on a convincing story or social media hype without checking the company's cash and costs, which show how long it can survive.
- Putting in more than you can afford to lose, which turns a bad outcome into a financial emergency.
- Having no exit plan, so a falling price turns into a hope that it will recover and losses grow.
Questions
People also ask.
Is a penny stock the same as a speculative stock?
Not exactly, because a penny stock is defined by a very low price, while a speculative stock is defined by uncertainty, although the two groups overlap often.
How much of a portfolio should be in speculative stocks?
Many advisers suggest a small share, often 5% or less, but the right level depends on your goals and ability to absorb losses.
Can they be good investments?
Some deliver very large returns, but many fail, so the typical result is poor and only a few big winners compensate. That is why position size matters more than picking the right stock.
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