Speculating Vs. Investing: Know The Difference
From The Desk Of Dan Seder
Bitcoin could be making history as the digital currency of choice. Bitcoin could also become history, with one damning comment from Treasury Secretary, Janet Yellen. The bottom line is the future of Bitcoin is unknown. It could double in price, or be cut in half. This level of risk and uncertainty makes Bitcoin more akin to a speculative opportunity than a long-term investment.
It’s important to understand the difference between investing and speculating. Let’s rely on Webster here for definitions:
Investment is defined as the action or process of investing money for profit or material result.
Speculation is defined as investment in stocks, property, or other ventures in the hope of gain but with the risk of loss.
While speculative opportunities can offer extraordinarily handsome rewards, most should be broached knowing the odds favor a significant, if not entire, loss of capital. Given what’s at stake, we encourage our clients to consider the following guidelines prior to speculating:
- Cover Core Capital
Speculating to “get rich quickly” is one of the best ways to go broke. Speculation should only be considered once your core capital requirement is met. Core capital refers to a dollar amount that, when reverse engineered, can produce enough dividend income to cover your basic living expenses.
Here’s the math assuming your basic living expenses are $10K per month:
- Annual cash flow required: $120K
- Reasonable dividend rate: 3%
- $120K / 3% = $4M
Said another way, a $4M portfolio should be able to reasonably produce $120K in dividend income. Therefore, if you require $10K/month for basic living expenses, you should only consider speculating with a portion of your “excess reserve” above $4M. This approach is a prudent way to ensure a 100% loss on any speculative investments will not impact your long-term financial plan.
- Stay Small
Once your core capital requirement is met, don’t bet the excess reserve farm. In fact, do the opposite. Start by carving out only 5-10% of your excess reserve for speculative opportunities. For example, if you have $500K in excess reserves, you would only consider speculating with $25-50K.
If you’ve met your core capital and identified a fraction of excess reserves for speculation, the final step is to diversify. Diversification means not putting all of your “speculative eggs” in one basket. We recommend choosing anywhere from 5-10 opportunities. The key here is setting your expectations correctly. The bulk of your speculative opportunities are likely to fail. However, one or two successful endeavors could more than make up for the difference.
We certainly don’t recommend that you speculate. However, if you’re so inclined, we encourage you to consider the guidelines above.