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Speculation and the proper portfolio

By Dr. Don Taylor · Bankrate.com
Monday, July 14, 2014
Posted: 6 am ET

© Mark Carrel/Shutterstock.comIf you're a regular reader of these posts, you'll know that for investors who actively manage their portfolios, I'm a fan of core-satellite investing.

With this approach to investing, the passive part of the portfolio is invested in broadly diversified index mutual funds or exchange traded funds (ETFs) based on an index, keeping a tight lid on fees and expense ratios. The balance is actively managed, where the investment manager is trying to beat the market.

The goal for the active portion of the portfolio is to earn a return, net of fees and expenses, above that of a benchmark portfolio.

There are different approaches to active management. Tactical asset allocation, market timing, sector rotation and momentum investing. Even value investing can be seen as active management in its search for undervalued (or overvalued) investments.

While speculation certainly is an active strategy, it typically is short-term in nature, more akin to trading versus investing and can involve a high degree of leverage by using options and futures to speculate versus just owning the underlying asset, like stocks or gold.

Bankrate's investment glossary doesn't define speculation, so I went with the Merriam-Webster definition as an: "activity in which someone buys and sells things (such as stocks or pieces of property) in the hope of making a large profit but with the risk of a large loss."

A Mark Twain quote on speculation certainly rings true with passive investors. He said, "There are two times in a man's life when he should not speculate: when he can't afford it and when he can."

I've always felt that there is room in an investor's portfolio for a small slice of speculation -- if they are interested in speculating. Typically, that slice should be no more than 5 percent of investable assets (not including a personal residence). The speculative piece comes after the emergency fund, after funding the 401(k) and/or individual retirement accounts (IRAs). Once you've handled the big picture, then you can consider it.

In my advice column, I get questions from people asking if they should put all their portfolio in gold or a single stock, usually one with a high dividend yield. The answer is going to be no, because they can't afford to concentrate their portfolio in that one investment.

I have a couple of small IRA accounts with an online brokerage firm, representing less than 1 percent of my investable assets. I like taking flyers on these accounts because I don't have to deal with the tax implications until I take distributions in retirement. It keeps me interested spotting areas of the market that I think are cheap, or rich. I'm not always right, but it's always an education.

Do you have a speculative component in your portfolio? What fraction of your investable assets does it represent?

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