Posted on October 28, 2010 by Rich Browne

The concept of “speculative risk” can be most usefully contrasted with the concept of “pure risk.”

A pure risk is something that will be bad if it happens to you, where there is no corresponding good (other than its absence). The risk of getting hit by lightning, the risk of having your town destroyed by a hurricane, the risk of having your planet destroyed by an asteroid impact, etc. are all pure risks.

But a speculative risk is a gamble you knowingly take that has both potential bad outcomes and potential good outcomes. For example, the risk that you will lose at the racetrack is a speculative risk. Why? Because you purposely put yourself in a position to possibly suffer that loss because doing so also gave you an opportunity to win.

Investments by their nature carry with them speculative risks. When you put capital into your business, or you buy a stock, or you invest in silver, you do so in the hopes of coming out ahead, but with the realization that you may come out behind.

There are different degrees of speculative risk. You might lose some or all of the money you invest in a Fortune 500 company, and you might lose some or all of the money you invest in a penny stock. These are both speculative risks, but the risk is vastly higher with the penny stock.

Now that is not to say that all investments, or all decisions, with higher speculative risks are worse than those with lower speculative risks. Because there are always other factors to consider. If a certain Fortune 500 stock carries with it a 1% chance you’ll lose all your money, and a 2% chance you’ll at least double your money in the next year, and a certain penny stock carries with it a 7% chance you’ll lose all your money, and a 20% chance you’ll at least double your money in the next year, depending on other factors, the penny stock may well be the better play.

Pure risk has no upside for individuals or society. The willingness of people to undertake speculative risks, however, can be a benefit to a society. Risk-taking behavior like investing and entrepreneurship can create jobs, generate taxes, foster technological advance, and lead to overall societal economic growth. Much of the philosophical justification for rewarding the “winners” in a capitalist economy is that the very fact that they took risks that they could have lost is beneficial to society and should be compensated.