What is a Speculative Stock
A speculative stock is a stock with a high degree of risk, such as a penny stock or an emerging market stock. 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 a 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).
BREAKING DOWN 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.
Often times, 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 under-perform in bear markets, because investors’ risk aversion causes them to gravitate towards larger-cap stocks that are more stable.
Typical valuation metrics like 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 like 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, while traders should be sure to use risk management techniques when trading speculative stocks to avoid sharp declines.