Speculate without losing your shirt

Sometimes we just can't help ourselves from doing dumb things. And it's not really our fault.

In his recent book, Your Money & Your Brain, author Jason Zweig discusses why we're motivated by the prospect of reward, whether it comes in the form of money, food, drink, or other primal, feel-good desires. Our brains reflexively light up when we're presented with the possibility of big financial gains, regardless of the odds (Zweig humourously points out that the brain scans of someone high on cocaine and someone who's thinking about making money look identical). And if you hit it big, even just once, you'll still keep trying to strike gold again. That explains why people buy lottery tickets and why jackpot winners keep buying more.

You may not play the lottery or gamble otherwise, but if you've taken a flier on a red-hot sector fund or bought a stock with iffy (but potentially explosive) prospects, you probably were motivated by some of the same biological impulses. If you're like most people, though, letting your base instincts rule probably won't lead to successful results. Just ask the people who poured billions of dollars into technology funds in 2000, lured by the gaudy gains they posted in 1999, only to lose most of their money in the ensuing bear market. When you take a roll of the dice, don't be surprised when your number doesn't come up.

I'm not much of a gambler or speculator. I'd rather invest--that is, I try to put my money where the odds of earning a good return are stacked in my favour. This means I look for funds with relatively low costs and seasoned, proven managements. In equities, I focus on companies with sustainable competitive advantages and reasonable valuations. Yes, my approach isn't a ticket to quick riches, but I'm slowly but surely building a nice nest egg.

Of course, you might say I'm not having any fun (I think I am, but perhaps I'm just easily entertained). I realise, though, that many of you may not be able to resist the temptation to speculate on the next hot sector or stock (by speculate, I mean buying an asset in hopes of big short-term gains or making a call on the short-term direction of the market, individual stocks, or commodity prices). The good news is that you can do so while still achieving your big financial goals. If you must, here are a few thoughts to keep in mind.

Eat your meat and vegetables before you get dessert
I didn't like it when my mother didn't let me eat dessert until I had finished the rest of my dinner, but I'm a tall, healthy guy today as a result, so she was obviously on to something. Likewise, you should indulge as an investor only if you have a well-diversified portfolio designed for the long term. You should have exposure to stocks of all different sizes and valuation ranges and you should be exposed to both domestic and international fare. Most investors should have a helping of bonds, too, particularly if they're nearing retirement. If you want to see at a glance what your asset allocation looks like, check out Morningstar's Instant X-Ray tool.

You can also use the tool to help you determine whether you're on track in meeting your financial goals. If you're not well on your way, you should be putting more money in your long-term investments rather than potentially gambling money away. This should go without saying, but don't make any bets with money you can't afford to lose.

Create a "mad money" account and limit its size
When you eat dessert, it's best to keep your portion modest. Similarly, if you must take a gamble on the market, your speculative bets, in aggregate, should compose a small portion of your overall portfolio (10% or less). Also, you should consider keeping your speculative holdings separate from your long-term investments in an entirely different account. Avoid comingling them. That will keep you from threatening the health of your nest egg. (It's worth noting, though, that keeping separate accounts will give you more paperwork to deal with than if you kept all of your investments in a single account.)

Once you create your mad money account, set your limits from the get-go. In my one and only trip to a casino, I limited myself to gambling no more than £100 (for some reason, I didn't get a night in the high-roller suite). If I lost it all, I told myself I'd be done for the night and would head to the buffet for dinner. It didn't take me long before I was munching on all-you-can-eat shrimp.

In your mad money account, you can limit your losses in a similar manner. Figure out right from the start how much you'll allow yourself to lose. Conversely, if you start making money, resist the temptation to add more money to the account. Remember that hitting the jackpot once doesn't make it any more likely you'll hit it again.

Make sure you're not doubling your bets
Before you place some of your chips on a narrow sector of the market, see if your existing holdings are already making the same wager. Let's say you're thinking about a financials-focused fund or exchange-traded fund because you want to bet on a sustained rebound in the bedraggled financials sector. But if you own a diversified fund that has a big stake in the sector, you might have enough financials exposure as it is.

Again, to get a big-picture look at how your entire portfolio breaks down from a style and sector perspective, you can use the Instant X-Ray tool. After entering in your fund and stock holdings, you'll get data on how your holdings compare with the market from a sector perspective. If you've already got above-average exposure in an area you thought about adding to, you might want to think twice before jumping in.

Remember the odds
As Zweig points out in his book, lightning seldom strikes twice. You might make a killing once by betting on a tiny drug company that strikes gold with a novel drug, but that doesn't make it any more likely you'll be able to do so again. Your financial health will be better off if you focus on sensible investments with real long-term merit. But if you find the urge to take big chances irresistible, don't do anything that imperils your financial security in the process.

A version of this article appeared on Morningstar.com on June 24, 2008.