Speculative Stock

What Is a Speculative Stock?

A speculative stock is a stock that a trader uses to speculate. The fundamentals of the stock do not show an apparent strength or sustainable business model, leading it to be viewed as very risky and trade at a comparatively low price, although the trader is hopeful that this will one day change. This may be a penny stock or an emerging market stock that the trader expects to become much better known very soon.

Many traders are drawn to speculative stocks due to their higher volatility relative to blue-chip stocks, which creates an opportunity to generate greater returns — albeit at greater risk. Most long-term investors and institutional investors stay away from speculative stocks unless they are part of a mutual fund or exchange traded fund (ETF).

Understanding a Speculative Stock

Speculative stocks appeal to short-term traders due to their low share price and greater volatility compared to traditional blue-chip stocks. The greater volatility enables traders to realize windfall profits if the trade works out in their favor. The challenge is to find ways to limit losses if the trade does not work out.

Oftentimes, speculative stocks are clustered in sectors such as mining, energy, technology, and biotechnology. While there is significant risk involved in investing in early-stage companies in these sectors, the possibility that a small company may find a giant mineral deposit, invent the next big app, or discover a cure for a disease offers enough incentive for speculators to take a chance on them.

Although most speculative stocks tend to be early-stage companies, a blue-chip can occasionally become a speculative stock if it falls upon hard times and has rapidly deteriorating prospects for the future. Such a stock is known as a fallen angel and may offer an attractive risk-reward payoff if it can manage to turn its business around and avoid bankruptcy.

Investing in Speculative Stocks

Speculative stocks generally outperform in very strong bull markets when investors have abundant risk tolerance. They underperform in bear markets because investors’ risk aversion causes them to gravitate toward larger-cap stocks that are more stable.

Typical valuation metrics such as the price-earnings (P/E) and price-sales (P/S) ratios cannot be used for most speculative stocks since they are generally unprofitable and may have minimal sales. For such stocks, alternative techniques such as the discounted cash flow (DCF) valuation or peer valuation may need to be used to account for future potential rather than current fundamentals.

Speculative stocks often account for a small portion of portfolios held by experienced investors because such stocks may improve the return prospects for the overall portfolio without adding too much risk, thanks to the beneficial effects of diversification. Experienced investors who dabble in speculative stocks typically look for companies that have good management teams, strong balance sheets, and excellent long-term business prospects.

Most investors should avoid speculative stocks unless they have the time to dedicate to research. Meanwhile, traders who choose to trade speculative stocks should be sure to use risk management techniques to avoid sharp declines. This is especially true during a recession when investors often pull their money from speculative stocks and seek safe-haven investments. A better strategy during more turbulent times is to invest in companies with low debt, good cash flow, and strong balance sheets.

A trader who invests primarily in risky stocks is known as a speculator.

Investing vs. Speculating

Investors and traders necessarily take on calculated risk as they attempt to profit from transactions they make in the markets. The level of risk undertaken in the transactions is the main difference between investing and speculating.

Whenever a person spends money with the expectation that the endeavor will return a profit, they are investing. In this scenario, a reasonable judgment is made after a thorough investigation that the endeavor has a good probability of success.

But what if the same person spends money on an undertaking that shows a high probability of failure? In this case, they are speculating. Success or failure depends primarily on chance, or on uncontrollable (external) forces or events.

The primary difference between investing and speculating is the amount of risk undertaken. High-risk speculation is typically akin to gambling, whereas lower-risk investing uses a basis of fundamentals and analysis.