Some Rules for Speculating

It’s worth starting by defining how ‘speculation’ differs from ‘investment’. Speculation is about risk taking. It is about trying to spot that one fledgling company in one hundred who will go on to be the new Microsoft or Google. The mantra of speculators is to get in, make a quick buck, and then sell the share hopefully for a big profit.

Investment, by contrast, is about selecting quality companies for a rational price that you’re happy to own a share of for the long-term. You still want capital growth but you’re happy for it to be steady capital growth, backed up by regular income in the form of a dividend.

In general, the sensible approach to making money from shares is associated largely with good investment decisions. It’s much easier to get rich slow with shares than it is to get rich fast. However, buying into established companies in sometimes mundane industries isn’t always as exciting as trying to beat the market with some hot tip for a new company.

So, if you want to put some money into speculative shares, then here are some fundamental rules to adhere to:

1. Only invest what you can comfortably afford to lose. The nature of speculation means you are accepting a high risk strategy. There is every bit as much chance that your chosen company may crash and burn, as there is of it soaring.

2. View speculation as a supplement to an investment strategy. I would suggest no more than 10% of the funds you put into shares should be into speculative companies.

3. Do your research. Don’t just accept a tip from a friend or even from a newspaper, without questioning it. What is it that means that this company may have good prospects? Does it have decent cash flow? Do the management have a proven record with other companies? Are there barriers to entry that would make it difficult for other companies to come in and usurp your company?

4. Work out in advance what your criteria are for buying the share, and what they will be for selling it. The danger is that you buy the share when the good news about the company’s potential is already priced into the share (i.e. it’s already got a high Price/earnings ratio), and that you hold off on selling too long and see all your potential profit eroded.

5. Look for shares that have plummeted due to factors that are based more on the human propensity to panic than upon real deep-lying faults. Northern Rock might prove to be a recent example – a bank that had problems borrowing money from other banks which resulted in thousands of savers withdrawing their money and the share price being decimated. Richard Branson has announced that he’s interested in buying the company and suddenly the share price is on the way up again. What direction the share price takes from here, no-one can really know however!

6. Be clever and predict what the next trend will be. The difficulty with this is that you’ve got to see things that others can’t and this doesn’t happen much of the time. There’s also the possibility that a trendy sector can fail to produce on its promise – such as the first saga.

I will end be reiterating the risky nature of speculation. It is very similar to gambling – you are spending money generally in the hope rather than the expectation of achieving a fantastic return. I prefer to invest my money in more established companies, which have a proven track record and where high barriers to entry exist into their marketplace. However, there is no doubt that some people have made money from speculative gambles, so by all means feel free to match their achievements. Just don’t bet your house or life savings on it!