"October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February." -- Mark Twain, Pudd'nheadWilson (1894)
Mark Twain was bankrupt by the age of 59, which undoubtedly contributed to his cynical view of stock speculation. His most famous investing disaster was at least a $150,000 loss -- $4 million in today's dollars -- on the Paige Compositor, an automatic typesetting machine that Twain believed would revolutionize the publishing industry. Investing in a product that would make printing faster and more efficient seemed like a no-brainer. He wrote to his brother at the time, "The Paige Compositor marches alone & far in the lead of human inventions."
Unfortunately, the inventor of the machine, Mr. Paige himself, was a perfectionist who refused to let the machine go to market until it matched his vision. By the time Paige was ready (14 years later!) to let go of his baby, more efficient and less expensive competitors had entered the market and rendered the Compositor impractical.
Don't bet the farm
We can all relate to Twain's enthusiasm to invest in a potentially paradigm-shifting product or company. If it pans out, it's a surefire way to amass a sizable fortune (think buying Microsoft in 1990). On the other hand, if it fails, the results can be devastating (think buying Pets.com in 2000).
Despite its inherent risks, speculation isn't altogether unhealthy. After all, had the Compositor succeeded, this article would be about Twain's investing genius, the universities he founded, the writing programs he endowed, and the charities he started.
Twain's biggest mistake was simply this: Investing more than he could afford to lose. It seems like a fairly obvious concept, but it is one that constantly gets overlooked by investors. We tend to focus so much on the riches that may await us that we refuse to consider the possibility of failure.
Exactly how much you can afford to lose varies by individual. Some advisors say no more than 10% of your portfolio value should go toward speculative investments, but depending on your risk tolerance, that number can be higher or lower. For instance, if you're getting ready to retire, throwing 30% of your portfolio at a speculative play doesn't make much sense; however, 30% may make sense to investors in their 20s who can handle the risk and who have many working years ahead of them.
No matter how revolutionary an idea may be or how great a company's management appears, it has to become reality in order to be profitable. Many obstacles can befall a company on the way to superstardom (e.g., FDA rejections, lawsuits, or SEC investigations), and some are more difficult to foresee than others.
To reduce the risk that unforeseen circumstances can have on your nest egg, hedge your speculative picks with some more conservative ones in various industries. For example, if your speculative pick is a nanotechnology prospect with a high beta, like Altair Nanotechnologies (Nasdaq: ALTI ) or Nanogen (Nasdaq: NGEN ) , consider adding some dividend-paying blue chips such as Procter & Gamble (NYSE: PG ) , Johnson & Johnson (NYSE: JNJ ) , or PepsiCo (NYSE: PEP ) to your portfolio. These latter stocks are significantly less vulnerable to the market's whims or to zero-sum events.
Or, to instantly diversify your non-speculative equities, try an indexed mutual fund such as Vanguard Total Stock Market Index (FUND: VTSMX ) or an indexed exchange-traded fund such as SPDRs (AMEX: SPY ) . To read more about this strategy, click here.
The Foolish bottom line
Your goal in investing (besides making money) should be to enjoy it -- and not risk so much that you get discouraged by crippling losses as Twain did. There's room in almost every portfolio for the great growth that paradigm-shifting companies like Microsoft circa 1990 can offer. If you'd like some help finding prospects, let us help you select them wisely. Motley Fool co-founder David Gardner and his team at Rule Breakers specialize in recommending growth companies that could fundamentally alter the framework of their industries.
Todd Wenning does not own shares in any of the companies mentioned in this article. Johnson & Johnson is an Income Investor pick. Microsoft is an Inside Value pick. The Motley Fool has a disclosure policy.