Speculation is an investment approach in which the investor aims to buy or sell stocks, currencies or other assets solely to make a quick profit. In such cases, the investor is known as a speculator. It is an investment attitude that is widely frowned upon. This type of investment generally has a significant risk of loss – the speculator risks losing most or all of his or her initial outlay, but expects to make a substantial profit. The speculator’s motive is to take maximum advantage of market fluctuations.
Speculation is typically based on either expectations of a future event or a sense of how the whole investment market might react to such expectations.
Investors involved in speculation are commonly found in markets where security prices fluctuate considerably.
They play a vital role in markets by absorbing surplus risk and injecting much needed liquidity into the market by trading where other investors dare not.
People involved in speculation are only concerned with the short-term gain they can make on an asset. Whether or not it is good for society, of superior-inferior quality, has promising long-term investment qualities, etc. is irrelevant, as far as the speculator is concerned.
A speculator pays little attention to the fundamental value of an asset, and focuses entirely on price movements.
Speculation is particularly common in markets for real estate, derivatives, collectibles, fine art, currencies, commodity futures, bonds and stocks.
According to ft.com/lexicon, the Financial Times’ glossary of terms, speculation is:
“A high-risk investment strategy aimed at making quick, substantial gains from the buying or selling of stocks, currencies or other assets. Speculation is often based on expectations of a future event, or a sense of how other investors might react to such expectations.”
“In the stock market, speculation can be limited to the buying or selling of large amounts of penny stocks with the hope that retail investors might follow suit. Trading on the basis of speculation is called speculative trading. Those who speculate are called speculators.”
Speculation vs. investment
Sometimes the difference between speculation and investment is hard to distinguish. Whether somebody is being either speculative or involved in an investment activity depends on how long he or she expects to hold onto the asset, the type of asset, and the amount of leverage.
If you purchased a property because you wanted to rent it out, for example that would be an investment. However, if you bought twenty condominiums with the minimal down-payment, and resold them quickly at a considerable profit, that would be speculation.
People who save want their money to be super safe. If you invest your money, you want a bit more growth than you would get from saving it, so the risk is slightly greater. Speculation, on the other hand, carries a very high risk, but also the chance of making a lot of money quickly.
If you heard on the news that a major, catastrophic terrorist attack had just occurred in a major city like New York, Chicago, London or Paris, and bought $1 million’s worth of gold immediately, and sold that gold four days later for $1.2 million, your actions would be classed as speculative.
Speculation – economic benefits
Nicholas Kaldor (1908-1986), a Hungarian-British Cambridge economist in the post-war period, recognized the price-stabilizing role of speculators.
Kaldor said that those involved in speculation tended to even out price fluctuations due to changes in the demand-supply conditions by possessing ‘better than average foresight’.
Victor Niederhoffer, an American hedge fund manager – speculator – and statistician, described the benefits of speculation in ‘The Speculator Hero‘ as follows:
“Let’s consider some of the principles that explain the causes of shortages and surpluses and the role of speculators.”
“When a harvest is too small to satisfy consumption at its normal rate, speculators come in, hoping to profit from the scarcity by buying. Their purchases raise the price, thereby checking consumption so that the smaller supply will last longer.”
“Producers encouraged by the high price further lessen the shortage by growing or importing to reduce the shortage. On the other side, when the price is higher than the speculators think the facts warrant, they sell. This reduces prices, encouraging consumption and exports and helping to reduce the surplus.”
By risking their own capital in the hope of making a profit, speculators add liquidity to the market and make it much easier for other investors – such as arbitrageurs and hedgers – to offset risk.
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Speculation and economic bubbles
Speculation is generally associated with economic bubbles by the media and lay people. Economic bubbles occur when the price of assets exceed their intrinsic value by a considerable margin.
While some economic bubbles may pop partly because of speculative activities, this is often not the case, say economists. They link cash flows and discount rates more closely to collapsing markets.
A speculative bubble is characterized by rapid market growth caused by word-of-mouth feedback loops – initial rises in the prices of assets attract extra buyers and generate additional inflation.
The expansion of the bubble is followed by a mega collapse, which is fueled by the same word-of-mouth feature. A speculative bubble is essentially a social epidemic.
Henry Ford, an American industrialist, was the founder of the Ford Motor Company, and the sponsor of the creation of the assembly-line technique of mass production. He developed and manufactured the first car that many middle-class Americans could afford. (Image: Wikipedia)
John Maynard Keynes (1883-1946), a British economist whose ideas and writings fundamentally changed the economic policies of governments, wrote:
“Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation.”
Keynes himself was involved to a small extent in speculation when he ran an early precursor of a hedge fund. He was the Bursar of King’s College, Cambridge University, managing two investment funds.
Keynes did not only invest in the emerging markets, including the US market, but also speculated in foreign currencies and commodity futures. His fund averaged 13% per year growth, even during the Great Depression.
Video – Speculation
This Marginal Revolution University video explains what speculation is and why it is a vital part of the market process.