Speculative Capital

What Is Speculative Capital?

Speculative capital includes those funds earmarked by an investor for the sole purpose of speculation, which means that those funds are earmarked for high-risk/high-reward investments. This capital is often associated with extreme volatility and a high probability of loss. Most speculators have short-term investment horizons and often use high degrees of leverage in their efforts to obtain profits.

Speculative capital, also known as risk capital, can be contrasted with patient capital, which is intended to be long-term and oriented to well-researched, quality investments.

How Speculative Capital Works

Speculative capital is the funds that are considered expendable in exchange for the opportunity to generate outsized gains. Investors must be willing to lose all of their speculative capital, which is why it should only account for 10% or less of a typical investor's portfolio equity. Experienced investors with high-risk tolerance may allocate a quarter or more of their portfolio to higher-risk investments. That said, any investments made with speculative capital should be offset with more stable diversified investments so you don't face the possibility of losing your entire portfolio.

The more risk-averse the investor, the lower the proportion of speculative capital allocated in the total portfolio should be. While younger investors, because of their longer investment horizons, can have a more significant proportion of risk capital in their portfolios, retirees are not usually comfortable with a high proportion of speculation—nor should they be, as their time to make back losses is limited. Generally speaking, speculative investing should be segmented to the early years of investing and cordoned off as retirement age approaches.

Special Considerations

Given the above-average probability of loss in speculative trading, it is critically important to exercise good risk management and not become emotionally attached to a certain trade. It is not uncommon to see novice investors hold onto a position until it loses nearly all of its value. Given their limited experience, rookie traders should regard all their tradable capital as speculative capital. In other words, they should only invest whatever amount of money they can afford to lose without their way of life being materially affected.

Since no two investors are identical when it comes to risk tolerance and financial goals, designating certain portions of capital "speculative" will vary widely across investor archetypes. Perhaps a better method of identifying speculative capital is finding the amount an investor is willing (or able) to lose without jeopardizing their investment plans or financial goals. In reality, whenever there is a chance for loss, an investor is speculating. Even virtually default-free government T-bills may be speculative in nature; in a sense, investors are speculating on inflation.

Mental Accounting and Speculative Capital

Mental accounting is a common strategy for financial planners to accommodate the speculative itch for investor "play money." Mental accounting refers to the tendency people have to separate their money into different accounts based on miscellaneous subjective criteria, including the source of the money and the intended use for each account.

The theory of mental accounting suggests that individuals are likely to assign different functions to each asset group in this case, the result of which can be an irrational and detrimental set of behaviors. Because some investors like to chase trends, a financial planner can earmark a certain portion of assets or inflows, such as money from a bonus, for speculative transactions. This approach satisfies investors' desires for chasing returns, or stocks they hear about at neighborhood BBQs, but doesn't risk an entire portfolio.