A Look at Speculative Assets
Welcome to the Financial Casino!
What is speculation? If we turn to the Oxford Language definition, they have this to say: “Investment in stocks, property, or other ventures in the hope of gain but with the risk of loss.”
It is important to understand how this differs from investing in a productive asset. In the definition above, there is no implication of productivity on the part of the investment. Rather, there is hope that it will gain in value, but the recognition that it might not.
If you read my prior post on To Buy or Rent? you may recall my insistence that the home you live in is an expense and that this is the best way to look at that asset in your portfolio. I say this with my laser focus on getting you to financial independence. To recap: the home you live in is not a productive asset that adds to your income and cashflow, but that more typically detracts from it (except in cases where substitution for for rent results in lower expenses, which you can find in places like Detroit, Michigan).
But as that same post showed, you can come out ahead financially when buying a home to live in. However, to know it has been a truly profitable investment, two things must happen first: (1) you have to sell the home, and (2) once sold, subtract all of the expenses incurred during the ownership of the property, if there remains more money than you put into it, congratulations, you successfully pulled off investing in a speculative asset at a profit.
Millions upon millions of people since the end of WWII have been rewarded with profits after selling the homes they lived in - although, most fail to recall all the money they poured into it. This substantially inflates their perception of how profitable it has been, and is the source of their conviction when talking to younger adults as to why the young’uns need to buy a home (to live in).
Not Your Elder’s Economy
But this is not the same economy they spent their younger lives in. There are substantial indicators that the US economy has reached peak prosperity. What we have seen of recent attempts to grow our Gross Domestic Production (GDP) - a measure of our overall productiveness as a nation, including private and government production - appear to be more smoke and mirrors than actual growth.
What exactly is peak prosperity and why does this change matter? Peak prosperity is the high point in a society’s productiveness. While it is easier to know this in hindsight, at present we can look at key trends to inform this opinion: decreasing margins of profitability, massive expansion of government and private debt (excessive debt being a drag on profitability) and the absence of a new vehicle to increase per unit of labor (per working person) productivity - like the Internet from 1995-2015 and industrialization in the early 1900’s. IF we are on the decline from peak prosperity - which may not merely be a national phenomena, but a global one - investing in speculative assets becomes a very risky business.
So, let’s look at what speculative assets Americans invest in most frequently today:
The home they live in. This is, for most people, the biggest asset they ever own. Since this asset generates no income while the owner possesses it, any gains are a function of speculation.
The mutual funds in their employer retirement accounts (401k, 403b, etc.). While these assets are not an ongoing expense like the home you live in, investment in these represent an opportunity cost (an opportunity cost being that investment in these assets precludes you from investing or using that same money for something else).
Non-dividend-yielding mutual funds, stocks and ETFs held either in an individual retirement account (IRA) or non-retirement brokerage account.
Investment properties purchased as fixer uppers to be improved and then resold (known as a Fix & Flip) at a profit after the improvement.
Collectibles. This can range from artwork to cars to coins, comic books, beanie babies, pig themed kitchenware…the list goes on and on.
Cryptocurrencies. The largest of these by far is Bitcoin, but there are now an astounding 20,997+ cryptocurrencies being traded in some fashion around the world. For now, I place all cryptocurrencies into the speculation bucket. If one were to exist that pays a periodic dividend in US dollars or other global fiat currency to the holder of the asset, I would not include it on this list.
Investment properties purchased to move funds out of financial markets and into real estate with no expectation of operating it at a profit.
Apart from the very wealthy, most Americans do not engage in this kind of speculation in other countries, but it is nonetheless an option that some choose to diversify their portfolio of assets. This type of investing to move money from China into the US has been very common in the past decade+ and has been a factor in the rapid rise in home values on the Pacific Coast in particular.
I ordered these by roughly the scale of investing in these segments US investors engage in. Equity in one’s primary home and savings in employer retirement accounts represents about 70 percent of Americans net worth across a wide band of of the economic spectrum (including everyone but the top 10% of American households).
On the surface, it appears too many Americans are taking a casino approach to their investing practices, especially those closer to retirement. But let’s delve a little deeper into what makes speculative investments speculative.
Speculative Assets Three Ways
With careful consideration you begin to see at least three components to the growth of most speculative assets.
The first component is somewhat illusory: Inflation. I say illusory because this component is less a function of the asset’s increasing value as it is a function of the near continual devaluation of the currency in which the asset is valued, which, for Americans, is the US dollar. What the asset is really doing, in part, is holding its value as the dollar’s value declines.
To give you an idea of how potent this effect can be, let’s look at gold, a popular speculative asset. In September of 1922, an ounce of gold could be purchased for around $20.80 cents an ounce. 100 years later, in September of 2022, an ounce of gold is around $1,686. So this inanimate, non-productive asset has increased in value 81 times. But it, in itself has not really increased in value relative to other material assets that much. Rather, the dollar in 1922 terms has been devalued to a mere 1.2 cents!
A second major component of a speculative asset is its potential. That being the potential for that asset to grow in value. For instance, a share of stock in a software company with a promising but not yet released product will often gain value based on the anticipated future value of the work they are engaged in. Think of Apple, whose stock increased 40% in value between their announcement of the iPhone (January 2007) and the date the first iPhone was officially sold (June 2007).
The third major component of a speculative asset is its potency. When a company begins to deliver reliable earnings increases quarter in and quarter out, the value of the stock representing ownership in that company generally increases.
When we look at these three components, depending on the asset, it can have varying degrees of speculation.
An asset that has no potential or potency is really hoping to hold its value against other tangible assets and gain against currency that is being devalued. This is also known as an inflation hedge. Gold, since it doesn’t rust, decay or otherwise dissipate, is a prime example of this type of asset. When one speculates in gold, any expectation that it will gain against other assets (besides the US dollar) is based on its durability compared to those other assets.
The success of speculating in an asset that is all potential - like interest (i.e. stock or other form of ownership) in a startup company - will depend on whether that company can deliver a product that meets the level of anticipation that drove the value of the stock before the product existed.
Speculation in an asset with potency is usually really speculation on all three of the components I’ve described, since most successful companies are engaged in development of new products (potential), possess real assets to perform their operations (inflation hedge), and deliver regular profits (potency).
All Boats Drop in a Lowering Tide
Now, let’s go back to the conundrum of Americans being over invested in speculative assets. As I've outlined above, they vary by types of speculation, some types more risky than others. But one important phenomenon that should not be ignored is this: when panic sets into financial markets, like in 2008, nearly all speculative assets can lose significant value in a short timeframe. This was true of stocks, bonds (and the mutual funds comprised of these assets), housing, collectibles and most other assets people bought to hold on a speculative basis.
Some acquired those assets using borrowed money, and when the values dropped, depending on the means of borrowing (a topic for another post), many were forced to sell these assets after they had suddenly lost significant value to satisfy debt obligations.
Such historical realities inspired my fifth investing principle: Never acquire assets for the sole purpose of speculation with borrowed money.
An important aside: Since I’ve included the home one lives in as a speculative asset, does that mean don’t borrow money to buy the house you live in? That depends. If you can justify the benefit on the basis of substitution for rent, you should still buy it. If not, you might consider a better approach to accelerate your path to financial independence.
A Compound Lack of Interest
Looking back, I knew many who borrowed against their primary homes in the mid-2000’s to buy stocks, only to realize their mistake in 2008, and get doubly hammered when their homes lost half their value, leaving them with bigger loans than the respective values of their homes.
There’s a dynamic that takes hold in such downturns, compelling people to walk away from their homes in large numbers: When their home becomes worth less than the loans they have against it. This activity forces values even lower in an already down market.
Closing Reflections on Speculative Assets
To be within a decade of retirement and have 70% of your assets tied up in speculative assets is a risky business in today’s economy. A major market crash in both stocks and housing, like the financial crisis of 2008, could cut their overall holdings in half. During the depression, stock assets declined by as much as 90%. If we follow the popular wisdom of selling 4% of one’s stock/bond holdings each year to live off in retirement, the income they thought they’d have could be devastated right at the end of their working lives.
I would recommend structuring more of one’s investments toward income generation rather than speculation. In the 2008 financial crisis, those who invested in residential property with cash flow as their litmus test weathered the storm quite nicely and enjoyed the bonus opportunity of seeing massive additional opportunities to invest in more productive assets as home prices cratered.
Am I saying not to invest in speculative assets? No. My best performing investment by far was a speculative asset. But, here is what I would say about investing in this type of asset:
Always pay cash (or trade a similar such asset) for any speculative asset you acquire. Never borrow money for this purpose.
Limit the bulk of your speculative investments to those with a clear potential for financial gain. An obvious example being the match you receive from your employer when funding mutual funds in your 401k retirement account. Another is buying a house to live in that lowers your expenses compared to rent.
Limit your investment in inflation-hedging assets to no more than 10% of your total invested assets. Once you get older than 50, a good case can be made for allocating a higher percentage to this segment.
Limit your highly speculative investments - the kind you think could yield multiples of the original investment - to no more than 5% of your total invested assets, regardless of age. The exception to this is when one begins to take off and swells in relation to your total investments. In this case, have an exit strategy in mind, including, for instance, taking some gains to lock them in as it grows.
Until next time, may peace and prosperity be with you.
The Natural Economist
Next up: The Hazards of Perception vs. Reality in Financial Investing