What to know about speculation: When investors buy high-risk assets with the expectation of significant returns

• Speculation is the act of buying or selling assets that have an increased chance of significant losses.
• Speculation is common among investors who trade penny stocks and over-the-counter (OTC) investments.
• Speculation should be limited to ensure that long-term financial goals like retirement are not impacted.

The bulk of investing advice, especially for those interested in retirement centers, are around slow and consistent gains over decades. But not every investor is content with the prospect of patient long-term gains. Some would rather aim for the home run trade - a move that could change their fortunes overnight. This is known as speculation and it doesn't come without significant risk.

What is speculation?

Speculation is the act of buying or selling assets that have an increased chance of significant losses. As speculative investors take on more risk, there's an expectation to achieve extraordinary returns which - in the mind of speculators - is compensation for the outsized risk.

Speculative investors tend to be active traders. This means that they're attempting to beat the market average and have more of a hands-on approach, especially during short-term swings in the market. This is a stark contrast to more passive, buy-and-hold investors who generally have more of a hand-off approach and do not adjust their investments as often.

The decision-making process for speculative investors can vary wildly in terms of sophistication. Some speculators base their investing decisions on social media groups and memes. This was, and still is, the primary driver behind the surge in stock price for companies like GameStop and AMC Theaters. Both companies were mired in financial trouble and at different points rumoured to file for bankruptcy prior to 2021.

Another example is Dogecoin, a cryptocurrency that saw massive spikes earlier this year when celebrities like Mark Cuban and Elon Musk discussed it on Twitter. After Elon Musk's Saturday Night Live appearance on May 8, 2021, Dogecoin fell more than 30%. A series of Musk's tweets were also blamed for the volatility in Bitcoin when Tesla announced it would take Bitcoin as a form of payment in February - only to reverse that decision in May and deciding again that the company will accept Bitcoin in June. In April, the price of Bitcoin was slightly above $65,300 which is significantly more than the current price of Bitcoin at $33,600 at the time of writing.

Other speculators base their decision on a "hunch" or market volatility, says Sabina Smailhodzic Lewis, CFP® and co-owner at Avant-Garde Wealth. "They're looking for pieces of information that scream potential to them and risk to everyone else," she added.

Nearly every market has a speculative corner, but in today's investing environment, cryptocurrencies followed by NFTs (non-fungible tokens) are likely the most speculative.

How does speculation work in investing?

Speculation works when an investor has a strong worldview or prediction about an industry. Next, they typically identify a catalyst or event likely to spark a significant movement toward their initial prediction. If a speculator feels that the event is likely, they'll buy assets they believe will benefit them most if their prediction comes to fruition.

An example might be the 2020 election cycle. At the time, many believed that if then-former Vice President Joe Biden won the presidency, that cannabis would be legalized on a federal level. Thus, companies like Tilray (TLRY), Canopy Growth Corporation (CGC) and Aurora Cannabis (ACB) were ground zero for speculators.

Speculation is common among penny stocks and over-the-counter (OTC) investments. Companies that trade on OTC markets are not listed on formal exchanges like the New York Stock Exchange (NYSE) or the NASDAQ. These investments tend to be inexpensive - usually less than $5 per share - but are highly risky because of the lack of oversight and their generally shaky financial histories.

In March 2020, the rental car company Hertz was trading as low as $0.41 cents and was delisted from the NYSE just days before the company filed for Chapter 11 bankruptcy. Hertz then began trading on the OTC markets under the ticker symbol HTZGQ. Due to speculators betting on the company, Hertz stock price soared more than 1,100% within just two weeks during the summer of 2020.

Quick Tip: While not as common, speculation can also occur in venture capital markets and angel investing for new, up-and-coming companies.

Speculation within the forex and bond market

Foreign exchange (forex) is a highly speculative market in which investors trade currencies like the US dollar, Japanese Yen, and British Pound without a centralized exchange. The objective for Forex traders is to take advantage of short-term price movements between currencies. Forex, for individual investors, relies heavily on margin and leverage.

The Commodity Futures Trading Commission (CFTC), the federal agency that regulates forex, requires a minimum of 2% deposit for trading, which means that $1,000 in a Forex account can invest up to $50,000, translating to a 50:1 ratio. If the investment moves in a positive direction, an investor can profit quickly - but if the market moves unexpectedly, a small $1,000 investment could result in thousands of dollars in debt.

In the bond market, the line between investing and speculation is defined by bond rating agencies like Moody's, Standard and Poor's, and Fitch. Bonds that are considered strong, with a high likelihood that investors will receive their interest payments and principal, are known as "investment grade." Bonds with the lowest ratings are considered "speculative" and are sometimes called "junk bonds." Speculative grade bonds, however, often pay a higher interest rate to investors as compensation for the increased risk.

Quick Tip: The rule for margin and leverage can vary based on the regulatory agency and the investment type. The Federal Investment Regulatory Authority (FINRA) regulates brokerage firms and requires a 25% minimum equity in margin accounts at all times.

Speculation vs. investment

In some circles, the terms speculation and investment are used interchangeably. But, practically, there are some key differences in the level of risk and the types of financial instruments used between investors and speculators.

"Someone who might be more speculative is typically higher net worth or they have more knowledge about a particular market or industry," said Tremaine Wills, a financial planner at Mind Over Money in Newport News, VA. That specialized knowledge and higher disposable income can result in a higher tolerance for risk than the average person she added.

The financial takeaway

Speculation is not for the faint of heart. While the allure for big-time gains are present, it may be wise to consult a financial planner to ensure that you are not taking on more than you can handle. Also consider taking a risk tolerance questionnaire to help prepare and understand how you may react to losses.

Finally, make sure that you have a plan in place to address your immediate, short-term and long-term financial goals and keep them separate from any speculative moves you may have in mind.