In an article for Morningstar, John Rekenthaler offers 5 red flags that investors should be on the lookout for, as they could signal an investment is really a speculation in disguise:
“No track record.” Brand-new investments have the advantage of high expectations, because they haven’t failed…yet. If its initial performance is strong, investors will flock to it. But in reality, it simply hasn’t faced a situation where its disadvantages are highlighted. When that happens, investors will become disillusioned and sell off quickly. Although many of those investors may go on to buy another untested investment, many will learn from their mistakes; while investors are still likely to be tempted by SPACs, they are more patient nowadays than in the past.
“A lack of cash.” Many speculations use their potential as an enticement to buy, banking on the expectation of future profits and the belief that investors will eventually be able to sell off at a higher price. They’re selling their vision, not their revenue stream. And sometimes, cashless assets do pay off. But, Rekenthaler writes, for every investor who has made a fortune in a speculative bet, there are dozens more who have lost their shirts. Buying equities is already a difficult way to generate income, and those are generally expected to bring in high returns in the long run. Securities such as collectibles, which can’t accrue profits, is an even more difficult route.
“A secret sauce.” Many speculations claim to have a secret strategy that is just too hard for regular investors to understand. They’re either being untruthful, or their strategy really is too complicated, Rekenthaler contends. When things go sideways, their inability to decipher their own strategy will be their downfall—as well as their shareholders’.
“Ignoring history.” While looking to the past for some clue of what might come can be useful, even market historians can’t predict the future. Inflation is a good example; long bonds have thrived over the last 40 years, seemingly disproving the lesson from the 1970s that bonds will suffer under inflation. But now, bonds are getting battered by high inflation, foiling those who thought that lesson was long in the past. Additionally, Rekenthaler advises not listening to portfolio managers who claim that “this time will be different.” It might be—but probably not in the way they expect.
“Special membership.” Avoid getting enticed into buying what’s billed as an “exclusive investment.” Retail investors don’t bring in enough money to be given special treatment, and usually an offer like this is a scam. “Investment exclusivity” can come in many forms, including the “liquid alternative” funds that don’t post the gains from elite hedge funds but still charge 2% a year, and SPACs, which purport to give retail investors the opportunity to be the first to buy into public offerings but then give better deals to their bigger shareholders.
Of course, it’s always possible that a speculative bet will display all these signs and still pay off. But it’s important that investors go into these trades, which Rekenthaler calls “gambles, not investments,” with their eyes wide open.