Diversification by Speculation
by Daniel Cross, ChFC
There is a naughty word whispered occasionally among investors. It has been heard in homes, jobs, and golf courses across America and equally met with fear and derision. A cold shiver runs down the spine of many an investor that hears it spoken aloud. The word is: speculation.
It has been demonized in the mainstream media, but speculation belongs in every investor’s portfolio whether you’re an aggressive day trader, decades away from retirement or a conservative, income-based retiree. The mere mention of speculating in a retiree’s portfolio is enough to send many financial planners sputtering in outrage and disbelief, but a fundamental understanding of what a truly diversified portfolio is and what it’s supposed to do should shed some light on this shadowy subject.
To understand speculation’s place in a portfolio, one must first define what diversification really means. To many investors, it means to have a mixture of equities and fixed income products to mitigate risk. This idea is an oversimplification that doesn’t take into account the various characteristics of a single investment such as beta, market cap, industry, and many other factors. The ideal portfolio would have a mixture of all of these from a basic savings account to an emerging markets fund. The point is that no single investment should carry a disproportioned weight that can swing a portfolio’s profits or losses solely by its performance.
While there is a negative stigma associated with the more speculative investments, most people overlook the possible defensive capabilities this can have. For the aggressive investor, speculating in atypical investments such as art, hedge funds, limited partnerships, and real estate can provide significant downside protection as many such investments are not directly related to stock market performance. Market fluctuations and even recessions can be effectively hedged using this strategy.
For the conservative investor, the benefits of speculation are not so readily apparent. The primary risk associated with these portfolios is underperformance. Fixed income based portfolios often struggle to keep up with inflation, especially during long bull market periods where it can rise dramatically like it did in the eighties. Keeping a portion of your portfolio in equities, emerging markets funds, and high-income corporate bonds (also known as junk bonds) can help you keep up with inflation much better.
Speculation also serves an ancillary role by keeping investors interested in their own accounts. Putting money into investments you believe in such as green energy, or pharmaceuticals will keep your attention on your money much better than just sticking it into a couple of random mutual funds and forgetting about it. Noted CNBC personality Jim Cramer is an advocate of this. He speaks of speculation as a way of “keeping you in the game” to help investors stay focused on their goals and monitor their overall portfolios and thus avoid the nasty surprises that afflict the unwary.
Used wisely, speculation serves an important purpose in any investment portfolio. By obeying the rules of diversification, you can use it to balance your investments and keeps you on the road to your ultimate goals. Keep all this in mind, and the next time you hear someone mention speculators, you can proudly say you’re one of them.