5 Signs Your Investment is Actually Speculation

Are you being promised exclusive access to secret sauce? This is how it could be a hustle.

John Rekenthaler 12 August, 2022 | 4:48AM
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Quick Sand sign

A reader recently forwarded me an article bearing the indelicate title "On Bullshit in Investing."

Its author was Benn Eifert, managing partner of a San Francisco-based hedge fund. Rarely do I agree with hedge-fund executives – and especially those who run absolute return strategies, which I have deemed “an aspiration, not a realistic investment objective.” However, that headline looked promising.

Happily, the book matched its cover. The article made excellent sense, albeit for the vainglorious reason it overlaps so strongly with this column. Among the targets Eifert and I have shared are Special Purpose Acquisition Companies, ARK Innovation ETFAllianz Structured Alpha, and Infinity Q Diversified Alpha, the last of which, I mused, might be the worst-ever public fund. (Bernie Madoff, of course, handily captured the private fund honours.)

Eifert offers five red investment flags. I wholeheartedly agree with them all. However, there is room for additional discussion, as animal manure is such a fertile subject. In that spirit, here are my five signals for when an investment is really something else: a speculation in disguise.

Sign 1: No Track Record

New investments benefit from high expectations. After all, they have not yet failed. If a new security’s initial performance is strong, investors rapidly begin to believe that a better mousetrap has been invented at last. Rarely has it. Rather, the investment has not yet faced an environment that spotlights its disadvantages. When it does, their disappointed owners are often quick to sell. Many then buy another untested issue, repeating the cycle.

Fortunately, investors have to some extent learned from their mistakes. When I started at Morningstar, in the late 1980s, the largest mutual funds were brand new: government-bond funds that boosted their “income” (in truth, those distributions were short-term capital gains) by selling options. Once their shareholders realised what they owned, they fled, and those funds quickly vanished. Today’s investors are harder to fool. To be sure, they can be tempted, as with SPACs, they tend to be more patient than their predecessors.

Sign 2: A Lack of Cash

Hope is a powerful lure. They may not look like much today, but just consider their potential! The expectation consists either of future corporate profits, for emerging companies that are long on vision and short on revenues, or in the belief that the investor will eventually be able to sell the security at a higher price even if it never can distribute cash. (The obvious example is cryptocurrency.)

Cashless assets do sometimes blossom into terrific investments. We all have all heard the stories of those who became fabulously wealthy by holding the shares of profitless companies before those businesses become household names. (Usually, it happens for initial employees, but it can occur for outside shareholders as well.) That said, for every acclaimed winner there are dozens (if not hundreds) of forgotten losers. Buying tickets is a tough way to make a living, even with equities, which have high expected long-term returns. It is tougher still when attempted with securities that can never accrue profits, such as collectibles.

Sign 3: A Secret Sauce

This item, I confess, echoes one of Eifert’s cautions, which counselled against “overly complex investments with non-transparent sources of return.” So, beware investments from people who would have you believe their strategy is too difficult for mere mortals to comprehend. Either they are being disingenuous, or their strategy really is indecipherable – to them as well as to outsiders. When disaster strikes, their shock will match those of their shareholders.

This occurred most (in)famously in 1998 with Long-Term Capital Management. According to a state treasurer who decided against committing money to the organisation, Capital Management’s principals suggested he was wise to refuse, since he did not appear to be smart enough to understand their investment process. As it turned out, neither were they. Shortly thereafter, the fund went bankrupt, being unable to service the debt it had assumed.

Sign 4: Ignoring History

Market historians have no monopoly on insight. While previous events offer a useful guide for what may come, they by no means necessitate the future.

Consider, for example, inflation. For 40 years, long bonds repudiated the apparent lesson of the 1970s, by thriving and prospering. But this year those securities took a beating, confounding those who, swayed by recent history, had decided the experience of the 1970s was no longer valid.

However, as with owning lottery stocks, betting against the past defies the odds. Usually, the “New Normal” ends up looking much like the Old Normal. For example, when Bill Gross used that term to argue that 2010s would be a lost investment decade, featuring “inexplicably low total returns” for bond and stocks, the opposite occurred. It was a golden age for investing, as with the 1990s.

Avoid portfolio managers who claim to know how “this time will be different” then. It probably won’t be. Even if it is, it may not match their expectations.

Sign 5: Special Membership

My fifth and final warning is against pledges of investment exclusivity. When portfolio managers offer everyday shareholders the opportunity to invest with the elite rather than with the usual huddled masses, the best response is to hold onto one’s wallet. It’s delightful to receive special treatment. Unfortunately, retail investors are not special; they don’t bring enough money to the table to merit the extra attention. The only reason to make such an offer, then, is to hustle them.

Thus come the “liquid alternative” funds that charge 2% annually but do not post the gains of the top hedge funds. Or SPACs, which supposedly offer retail investors the chance to purchase initial public offerings at the ground floor but cut different and better deals for their larger shareholders. Or separately managed accounts, which for years – although this shortcoming is improving, fortunately–sold the promise of customised portfolios without delivering that benefit.

Wrapping Up

Speculation can be lucrative. Securities that violate my precepts–or Eifert’s–may become spectacularly successful, particularly when money is easy, as during the past several years, before the Federal Reserve raised interest rates. Also, sometimes people enjoy playing with their portfolio’s house money, and there’s nothing wrong with that. Therefore, I do not counsel strictly against buying assets that carry these warning signs. However, one should do so with clear eyes. Such trades are gambles, not investments.

John Rekenthaler is vice president for research at Morningstar. While Morningstar typically agrees with his views, they are his own.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
ARK Innovation ETF47.66 USD2.21Rating

About Author

John Rekenthaler

John Rekenthaler  is Vice President of Research for Morningstar.

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