Speculation often gets a bad rap as it is the last reason standing after any crash.  And in that some of the criticism is justified.  The larger issue is when people think that they are investing when they are actually speculating – long and very wrong, as they say.  The easiest way to define speculation is if you are punting without a good sense of why.  There is a lot of hoping and praying involved.  When you understand the risks/return as well as the underlying drivers of that equation then you approach it as an investment.  The most pronounced example in the individual investor space is the story stock.  Unscrupulous entities will take a legitimate story, say infrastructure as a trend, and stretch it beyond its logical bounds.  There is good reason in believing in the sector.  It is highly visible in the media in the most favorable tones.  There are also good emerging successes in the sector, say GMR for example.  The pitch goes something like this: “Infrastructure is a sun-rise industry, look how well GMR has performed.  I have a stock that is just like that but for a fraction of the price.  All my clients are buying it.”  At first glance this seems very plausible, even compelling.  Here is the slight of hand.  What works for GMR doesn’t necessarily apply for all stocks in that sector.  Two, a lower absolute price doesn’t mean the stock is cheaper.  Worse yet, when you buy this stock it actually does what he said it would – it goes up in price - sometimes handsomely.  A rising tide lifts all boats.  But when the market corrects sanity return to the valuations you are left holding worthless paper.  We can relate to the viscerally because we have partaken in some form of this play.

 That brings us to our first lesson in speculation – it you against your own greed, you want to believe.  Two, you could have booked good profits had you sold in time – these are always short term plays.  The biggest mistake then is to enter in to a speculative position and the hold on to it as an investment.  Speculation per se is not a bad word if you know what you are doing. 

This is the preferred province of the Hedge Funds.  Hedge? You can’t say finance guys don’t have a sense of humor!  What makes them good at this? Speculation is essentially statistical in nature. Guys who do well are ones that have learnt to control their emotions and follow disciplined systems.  You take multiple considered positions and some will outperform.  Ones that do can underwrite losses from the others.  This works because mathematically your profits can conceptually be infinite while you losses can only be hundred percent.  To do this well you need a tested system to find good targets and tools to manage risk dynamically.  On the more practical side it works best with larger corpuses which can withstand the attendant losses and let the winners run.  This is best approached qualitatively through models a not hunches – it is a learnt behavior. 

If you are asking: even if I made some profits, the losses along with transactions cost and higher taxes will make it unviable.  You are right on the money.  Enter leverage, almost synonymous with speculation.  Often each trade yields only a few basis points so funds use leverage to soup up absolute returns.  Statistical arbitrage like this is best left to the professional and even they crash spectacularly just as often. 

For an individual investor speculation’s best use is when you stack the deck in your favor and play only with a fraction of your capital that you are willing to lose entirely.  Say you work in a software product company and notice that you are getting a lot of request to develop credit card fraud detection systems.  You have also heard about this small company that is doing great work.  Its fundamentals are quite there yet but you believe this is a strong trend and this company has the technology to capitalize on it.  This is a punt, you can never be sure you thesis will play out, but you know the kinds of proxies to track to see if it is working.

Restrict yourself to 3-5 shares that you have a clear thesis on.  You also have to follow them more closely  as they tend to be more volatile.  A few key team members leave to form a competing company and you may have to sell.  How disciplined you are at selling will determine your success to a large part.  When do you sell?  Your first goal is to take out the money you put in, at this time you are playing with the houses money.  You do this by tranching your sale.  The average share returns around 16% so sell a quarter at this level.  Sell another quarter at 32%, the next at 64% and let the rest ride to 100, 200% if you like, but sell don’t be greedy.  For prices going south, book 50% at a loss of 8%, another 25% at 12%, wait for a month and if the prices don’t reverse sell it all.  Clearly these are rules of thumb, you can come up with your own.  The idea is to put some structure around it so that your emotions don’t run away with you.