Speculative Risk

What Is Speculative Risk?

Speculative risk is a category of risk that, when undertaken, results in an uncertain degree of gain or loss. In particular, speculative risk is the possibility that an investment will not appreciate in value. Speculative risks are made as conscious choices and are not just a result of uncontrollable circumstances. Since there is the chance of a large gain despite the high level of risk, speculative risk is not a pure risk, which entails the possibility of only a loss and no potential for gains.

Almost all investment activities involve some degree of speculative risk, as an investor has no idea whether an investment will be a blazing success or an utter failure. Some assets — such as an options contract — carry a combination of risks, including speculative risk, that can be hedged or limited.

Understanding Speculative Risk

A speculative investment is one where the fundamentals do not show immediate strength or a sustainable business model. Instead, the trader expects that the price may rise due to other reasons, or that future prospects will outshine the present circumstances. Such a security may have a high level of possible upside but also a great deal of risk. This may be a penny stock or an emerging market stock that the trader expects to become much more favorable in the future.

Some investments are more speculative than others. For example, investing in government bonds has much less speculative risk than investing in junk bonds because government bonds have a much lower risk of default. In many cases, the greater the speculative risk, the higher the potential for profits or returns on the investment.

A speculative risk has the potential to result in a gain or a loss. It requires input from the person looking to assume the risk and is therefore entirely voluntary in nature. At the same time, the result of a speculative risk is hard to anticipate, as the exact amount of gain or loss is unknown. Instead, various factors — such as company history and market trends when buying stocks — are used to estimate the potential for gain or loss.

Speculative Risk vs. Pure Risk

In contrast to speculative risk, pure risk involves situations where the only outcome is loss. Generally, these sorts of risks are not voluntarily taken on and, instead, are often out of the control of the investor.

Pure risk is most commonly used in the assessment of insurance needs. For example, should a person damage a car in an accident, there is no chance that the result of this will be a gain. Since the outcome of that event can only result in a loss, it is a pure risk.

Examples of Speculative Risk

Most financial investments, such as the purchase of stock, involve speculative risk. It is possible for the share value to go up, resulting in a gain, or go down, resulting in a loss. While data may allow certain assumptions to be made regarding the likelihood of a particular outcome, the outcome is not guaranteed.

Sports betting also qualifies as having speculative risk. If a person is betting on which team will win a football game, the outcome could result in a gain or loss, depending on which team wins. While the outcome cannot be known ahead of time, it is known that a gain or loss are both possible.

If you buy a call option, you know in advance that your maximum downside risk is the loss of the premium paid if the option contract expires worthless. At the same time, you do not know what your potential upside gain will be since nobody can know the future.

On the other hand, selling or writing a call option carries unlimited risk in exchange for the premium collected. However, some of that speculative risk can be hedged with other strategies, such as owning shares of the stock or by purchasing a call option with a higher strike price. In the end, the amount of speculative risk will depend on whether the option is bought or sold and whether it is hedged or not.