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Are You Engaging in Speculative Investing? Be Ready To Lose Money…

Have you ever found yourself dabbling a little bit into a stock that you don’t know a lot about but it’s just 100% you doing some speculative investing?  I’m not going to lie, I certainly have and I even do a bit today, but if you don’t have it under control (or maybe even avoid altogether) then you can really find yourself in a world of hurt.

If you have been following any of my book reviews then you should know that I just recently finished Dual Momentum Investing and wrapped it up with a review on Global Equities Momentum, a simply strategy that has beat the market by 5% over a 40-year period. 

Now that I am done with that book, it’s time to bring it back to some fundamentals and I thought that ‘A Random Walk Down Wall Street’ by Burton Malkiel would be a great place to start!

As I said, I even let myself do a little bit of speculative investing but the reason that I do that is because I feel like it allows me to scratch the itch, per se, but I don’t let it ever get above more than a very small percentage of my portfolio. 

I feel like by doing this, I allow myself to have a little bit of “fun money” and get to partake in all the craziness that is going on in the world with the Robinhood Traders of 2020.

It took me awhile to get to this point, though…

I started investing within the last 5 years so I’ve been pretty dang blessed with a lot of good investing years in my early career.  Even the one real downturn that I saw was with COVID and that market “crash” responded to all-time highs within a half a year…so much for the debate of it being the worst crash of all time.

But when you’re in the middle of these really long bull markets, it becomes easy to get wrapped up into things and to think that “stocks always go up” as Dave Portnoy famously has coined.

I mean, over time, I do agree with Davey Day Trader.  He’s actually 100% correct…if you hold for the long-term.

But when you get to the point where you see that stocks are always going to go up, regardless of valuation or earnings of the company, that’s when you can get in trouble… and that’s exactly what Malkiel showed us in a few different examples:

Tulip-Bulb Craze

The Tulip-bulb craze occurred in Holland in the early seventeenth century and really seemed to set the tone for some of these other bubbles as well.

In summary, these tulip-bulbs always had a certain amount of value but due to a non-fatal disease known as mosaic, the demand for these bulbs grew out of control.  Mosaic essentially would cause color change or “flames” on the tulips and it as people do, they become infatuated with things that are new or different, and this was absolutely no different.

When these tulips would get this color contrast with the normal bulb, they were often referred to as “bizarres” and the more “bizarre” that the tulip was, the more that it would be worth.

All sorts of people with different backgrounds and professions could see what was happening – no matter what the cost of the tulips were, it was a deal because they could instantly turn around and sell them for way more than they had even bought them for in the first place.

People would do literally anything that they could to get their hands on these tulips, including offering up their land, animals, housing, jewels, furniture, anything!  Anything that they could essentially take out a loan on, they would, to front themselves this money to be able to buy the tulips.

The thing that really blew my mind is that people were literally using options to buy bulbs as well.  They would bring on a call option that gave them the option to purchase at today’s price and sell at a future price for a short premium, meaning that if the tulips went up (like they always do, right?) then they were going to make a ton of money.

Personally, I won’t get too far into the weeds with options, mainly because I don’t know them that well at all because I know that if I start to actively learn about them, I will physically not be able to stay away, and it’s not something that I want to get involved in.

All about knowing yourself!

At the end of all of this, Holland went into a prolonged depression because just so many people were affected. 

There wasn’t really any real fundamental value or use to the tulips but people had no issues spending money on them.  To me, it honestly reminds me of Buffett’s stance on gold (and yes, I know that he just bought some ownership in Barrick, a gold miner):

“[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

But this isn’t the only example that Malkiel gives us of people blindly partaking in speculative investing…

The South Sea Bubble

To me, this kinda felt like a pump-and-dump scheme.  Basically, what happened is the South Sea Company borrowed $10 million from the government in exchange for exclusive rights to trade in the southern seas.  Doing this gave them a huge advantage over all others as they could literally trade however, they wanted to because they had exclusive rights.

It was a huge perceived value because many people in England felt that there were a ton of growth opportunities by trading in the southern seas.

Management of the company basically promoted the heck out of the company and just sparked this irrational belief in them, causing the price of the shares to escalate way above and beyond values that they ever should’ve been at.

How do you think that this story finished?

Pretty dang bad.  Tons of people lost tons of money, including Isaac Newton, who was famously quoted as saying, “I can calculate the motions of heavenly bodies, but not the madness of people.”

Well said.

Wall Street Lays an Egg

This final example is one that most of you have all heard of and likely have studied in school, so maybe it will hit home a little bit – it’s called The Great Depression.

From March 1928 – September 1929, the percentage gained in the stock market was equivalent to the total gain from 1923 – early 1928.  To me, that might be a major red flag that things are starting to get a little bit inflated!

Not only were new investors coming into the market, but people were buying on margin (borrowed money).  The total amount of money that was using margin to invest increased from $1 billion in 1921 to $9 billion in 1929.

Just a 900% increase.  That’s all.

Pool Managers in the market would simply take orders for different shares and buy and sell them to one another to inflate the pricing.  Essentially, the pool managers were taking the public’s money and selling it back and forth to each other to artificially inflate the share price. 

By doing this, they could create a seemingly rising value of a company and also kick that FOMO (a major reason momentum investing works) into gear for people where if they didn’t get in now, they had the fear of missing out on the company in its entirety.

It just became very clear that the market was all that people worried about.  They would eat, breath and sleep the market.

“You could talk about Prohibition, or Hemingway, or air conditioning, or music, or horses, but in the end, you had to talk about the stock market, and that was when the conversation became serious.”

Albert Wiggin, the head of Chase bank, even went to super extreme lengths to short HIS OWN COMPANY’s stock.  Can you imagine that?  We freak out nowadays if someone just sells their company stock, let alone shorting it.  Sure enough, he was able to profit from the massive runup as well as the inevitable drop in the share price.

On September 5, the market experienced the Babson Break, where Roger Babson had essentially predicted a market crash (for multiple years in a row) and as he was doing a speaking event, things really started to hit the fan.  That month, there were many more bad days than there were good days.

As share prices began to drastically drop, more and more margin calls were put out, meaning that the lenders of that $9 billion in margin were asking for the borrowers to put up some additional collateral. 

Well, the issue is that the margin was tied up in the stock market, which just went through a really bad turn, meaning that to cover that margin, those borrowers were likely going to need to dip into additional funds above and beyond what they needed to get approved for the margin in the first place.

This was a recipe for disaster.  Essentially, you’re being forced to sell your stocks low after you had just bought them high.

This then led to Black Thursday on October 24 and October 29 being one of the worst days in the stock market of all time…eventually leading right into many, many years of The Great Depression.

Maybe it’s just me, but does it feel like this is today’s world?  I really think that it does.

I mean, COVID isn’t over, but we’re at all-time highs in the market because of… stimulus money?  Or low rates?  Or something else?

Personally, I don’t see how the market is at all-time highs.  I mean, the main reason is because the top 5 companies in the S&P 500 make up 25% of the S&P 500, so they’re really carrying the weight right now, but these companies are just trucking through like nothing happened.

Sure, I get the thought that tech is becoming more valuable than ever before as we’re literally seeing the world change before our eyes and people are moving to become more and more remote, but it still seems just crazy to me.

For instance, let’s think about some of the cloud computing companies.  Yes, I think that cloud computing is the way of the future but I also think that it’s very, very young.  I do have some money invested into FSLY and also in a cloud ETF in WCLD, but those are ONLY in my speculative investments section of my portfolio which is pure fun money and less than 10% of my total portfolio.  And its money that I’m ok with losing.

But a lot of these companies that are on a tear right now are all without earnings and some don’t even have revenues!

I mean, TSLA is over $2K/share which is just insane to me.  Now I admit, I think TSLA has made some major strides as a company but people are doing nothing other than speculating on the future value of the company.  Which again, is fine, if it’s a very small amount of your portfolio…but I doubt that it is.

I have a friend that has a portfolio made up of FSLY, PINS, ROKU, LVGO, PGNY, and TSLA…oh, and he’s also using margin.

Now, he has made an absolutely insane amount of money this year, and that has a lot to do with some very lucky timing, but I am nervous that he’s just setting himself up for some major heartbreak in the future.

The thing that we need to remember is that speculating in the market is gambling, and there’s nothing wrong with gambling if you’re ok with losing 100% of that money.  If you’re not, then you better not gamble.

You need to keep on with the plan – finding companies that are at a discount to their intrinsic value and have a great opportunity for upside in the future.  A great way to do this is to simply utilize the Value Trap Indicator to try to avoid any pitfalls, but if you’re looking for something that is even a step before that, start with a few simple valuation ratios!