Merriam-Webster defines an “investor” as someone who commits funds for long-term profit with minimal risk, whereas a “speculator” is someone who assumes financial risk in the hope of profiting from short-term fluctuations.
Which one are you?
I’m asking because the explosive popularity of prediction markets like Kalshi and increasingly exotic leveraged exchange-traded funds make me think more folks are becoming speculators than investors.
Yet history is littered with investors who confused speculation with investing and paid a heavy price for it.
As Nobel Prize-winning economist Paul Samuelson said, “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”
Yet there are signs that individuals prefer Las Vegas-style products. According to Kalshi itself, there were approximately 2.9 unprofitable users for every profitable user in the month analyzed recently by The Wall Street Journal.
This works out to roughly 26% profitable and 74% unprofitable bets, hardly a winning financial strategy.
But what about buying leveraged ETFs that typically seek to double or triple the daily returns of different asset classes? These allow you to speculate on upward — or downward — market moves.
According to Jason Zweig, who writes “The Intelligent Investor” column in The Wall Street Journal, when the S&P 500. rose a little over 1%, more than two dozen leveraged ETFs gained at least 20% and at least seven lost more than a fifth of their value in a single day.
Zweig then went on to note that according to FactSet, 612 out of 772 U.S. leveraged ETFs are based on a single asset, not a whole index.
“The individual investor should act consistently as an investor and not as a speculator.”
BEN GRAHAM
By holding just a few stocks — or even just a single stock — the risks are even greater.
So, how much risk can you really take? I asked ChatGPT to compare returns for the S&P 500 (SPY) vs. the Direxion Daily S&P 500 Bull 3x Shares (SPXL) during the COVID-19 crash (Feb. 19-March 23, 2020).
SPY was down a scary 33.7%, but SPXL lost 76.8%. To put this in perspective, $100,000 at the peak would have dropped to $66,300 in SPY compared to $23,200 in SPXL.
And while 20/20 hindsight shows that the market rebounded, no one really knew what would happen as the pandemic unfolded.
It turned out that those “with nerves of steel” who hung in after watching their money fall 76%, SPXL finished 2020 up 8.2%, but SPY was up 16.7%.
Over many years serving as financial adviser to high-net-worth clients, I witnessed the power of fear firsthand.
When Lehman Brothers failed in 2008 and the Great Recession began, most of our clients held well-diversified/moderate risk portfolios. Many were down less than 30% from top to bottom, compared to the S&P 500, which lost about half during the downturn.
Yet I had grown men sitting in my office in tears, terrified over the prospects of “losing all my money.”
Without the benefit of a crystal ball to predict the future, we relied on history, which showed that investors were best served by staying invested and riding out the storms to advise these folks.
All but three took our advice and slowly watched as account values rose beginning in March 2009. The three who demanded we sell locked in losses and never fully recovered.
Downturns are a normal part of investing, but the question is how much of a downturn can you really handle without selling out of panic?
A Nobel Prize-winning study by psychologists Daniel Kahneman and Amos Tversky showed that fear of losing $100 hurts twice as much as the greed of winning $100.
That means to accept a 50/50 coin-toss gamble in which you could lose $100, most people would require a potential gain of at least $200-$250 before their greed overcomes their fear.
And the study notes that fear strikes instantly, while greed builds slowly.
The CBOE Volatility Index (VIX), often called the market’s “fear gauge,” clearly shows this. During prolonged bull markets, VIX typically hovers between 10-15. During the COVID-19 crash, the VIX surged to above 80.
With markets having enjoyed powerful growth over the past few years and the VIX sitting at about 15, this might be a good time for self-reflection to think about how much pain you could actually handle.
Could you truly manage the possible repeat of a 76% drop over just 32 days in a leveraged EFT without panic selling? Be honest with yourself.
And if you were invested back in 2007-2009, remember how you felt and what you did. Did you hang in there or sell at/near the bottom?
The goal is not to avoid every downturn. That’s impossible.
The goal is to build a portfolio you can live with when the next downturn arrives.
Do that and you have a much better chance of remaining an investor rather than becoming a speculator when the market gets scary.
