Speculation

Speculation

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In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum. Speculation typically involves the lending of money for the purchase of assets, equity
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...

 or debt
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...

 but in a manner that has not been given thorough analysis or is deemed to have low margin of safety or a significant risk of the loss of the principal investment. The term, "speculation," which is formally defined as above in Graham
Benjamin Graham
Benjamin Graham was an American economist and professional investor. Graham is considered the first proponent of value investing, an investment approach he began teaching at Columbia Business School in 1928 and subsequently refined with David Dodd through various editions of their famous book...

 and Dodd
David Dodd
David LeFevre Dodd was an American educator, financial analyst, author, economist, professional investor, and in his student years, a of, and as a postgraduate, close colleague of Benjamin Graham at Columbia Business School.The Wall Street Crash of 1929 almost wiped out Graham, who had started...

's 1934 text, Security Analysis, contrasts with the term "investment," which is a financial operation that, upon thorough analysis, promises safety of principal and a satisfactory return.

In a financial context, the terms "speculation" and "investment" are actually quite specific. For instance, although the word "investment" is commonly used to mean any act of placing money in a financial vehicle with the intent of producing returns over a period of time, most ventured money—including funds placed in the world's stock markets—is technically not investment, but speculation.

Speculators may rely on an asset appreciating in price due to any of a number of factors that cannot be well enough understood by the speculator to make an investment-quality decision. Some such factors are shifting consumer tastes, fluctuating economic conditions, buyers' changing perceptions of the worth of a stock security
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...

, economic factors associated with market timing
Market timing
Market timing is the strategy of making buy or sell decisions of financial assets by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis...

, the factors associated with solely chart-based analysis, and the many influences over the short-term movement of securities.

There are also some financial vehicles that are, by definition, speculation. For instance, trading commodity futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...

s, such as for oil and gold, is, by definition, speculation. Short selling is also, by definition, speculative.

Financial speculation can involve the trade
Trade
Trade is the transfer of ownership of goods and services from one person or entity to another. Trade is sometimes loosely called commerce or financial transaction or barter. A network that allows trade is called a market. The original form of trade was barter, the direct exchange of goods and...

 (buying, holding, selling) and short-selling of stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...

s, bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...

, commodities
Commodity
In economics, a commodity is the generic term for any marketable item produced to satisfy wants or needs. Economic commodities comprise goods and services....

, currencies
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...

, collectible
Collectible
A collectable or collectible is any object regarded as being of value or interest to a collector . There are numerous types of collectables and terms to denote those types. An antique is a collectable that is old...

s, real estate
Real estate
In general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...

, derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...

, or any valuable financial instrument to attempt to profit from fluctuations in its price irrespective of its underlying value.

In architecture, speculation is used to determine works that show a strong conceptual and strategic focus.

Investment vs. speculation


Identifying speculation can be best done by distinguishing it from investment. According to Ben Graham in Intelligent Investor, the prototypical defensive investor is "...one interested chiefly in safety plus freedom from bother." He admits, however, that "...some speculation is necessary and unavoidable, for in many common-stock situations, there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone." Many long-term investors, even those who buy and hold for decades, may be classified as speculators, excepting only the rare few who are primarily motivated by income or safety of principal and not eventually selling at a profit.

Speculating is the assumption of risk in anticipation of gain but recognizing a higher than average possibility of loss. The term speculation implies that a business or investment risk can be analyzed and measured, and its distinction from the term Investment is one of degree of risk. It differs from gambling, which is based on random outcomes. There is nothing in the act of speculating or investing that suggests holding times have anything to do with the difference in the degree of risk separating speculation from investing.

Sustainable consumption level



The speculator Victor Niederhoffer
Victor Niederhoffer
Victor Niederhoffer is a hedge fund manager, champion squash player, bestselling author and statistician.Victor Niderhoffer was born in Brooklyn to a Jewish family. His father, Arthur, graduated from Brooklyn Law School but went to work in the police. Victor’s mother, Elaine was a teacher....

, in "The Speculator as Hero" describes the benefits of speculation:
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.


Another service provided by speculators to a market is that by risking their own capital
Capital (economics)
In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...

 in the hope of profit, they add liquidity to the market and make it easier for others to offset risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...

, including those who may be classified as hedgers
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...

 and arbitrageurs.

Market efficiency



If a certain market—for example, pork bellies—had no speculators, then only producers (hog farmers) and consumers (butchers, etc.) would participate in that market. With fewer players in the market, there would be a larger spread between the current bid and ask price of pork bellies. Any new entrant in the market who wants to either buy or sell pork bellies would be forced to accept an illiquid market
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...

 and market prices that have a large bid-ask spread or might even find it difficult to find a co-party to buy or sell to. A speculator (e.g., a pork dealer) may exploit the difference in the spread and, in competition with other speculators, reduce the spread. Some schools of thought argue that this creates an efficient market. But it is also true that, as more and more speculators participate in a market, real demand and supply can become diminishing small compared to supply and demand which is a result of speculation and thus prices become distorted and bubbles appear.

Bearing risks


Speculators also sometimes perform a very important risk bearing role that is beneficial to society. For example, a farmer might be considering planting corn on some unused farmland. Alas, he might not want to do so because he is concerned that the price might fall too far by harvest time. By selling his crop in advance at a fixed price to a speculator, the farmer can hedge the price risk and is now willing to plant the corn. Thus, speculators can actually increase production through their willingness to take on risk.

Finding environmental and other risks


Hedge funds that do fundamental analysis "are far more likely than other investors to try to identify a firm’s off-balance-sheet exposures", including "environmental or social liabilities present in a market or company but not explicitly accounted for in traditional numeric valuation or mainstream investor analysis", and hence make the prices better reflect the true quality of operation of the firms.

Shorting


Shorting may act as a “canary in a coal mine” to stop unsustainable practices earlier and thus reduce damages and forming market bubbles.

Winner's Curse


Auctions are a method of squeezing out speculators from a transaction, but they may have their own perverse effects; see winner's curse
Winner's curse
The winner's curse is a phenomenon akin to a Pyrrhic victory that occurs in common value auctions with incomplete information. In short, the winner's curse says that in such an auction, the winner will tend to overpay...

. The winner's curse is however not very significant to markets with high liquidity for both buyers and sellers, as the auction for selling the product and the auction for buying the product occur simultaneously, and the two prices are separated only by a relatively small spread. This mechanism prevents the winner's curse phenomenon from causing mispricing to any degree greater than the spread.

Economic Bubbles


Speculation can also cause prices to deviate from their intrinsic value if speculators trade on misinformation, or if they are just plain wrong. This creates a positive feedback
Positive feedback
Positive feedback is a process in which the effects of a small disturbance on a system include an increase in the magnitude of the perturbation. That is, A produces more of B which in turn produces more of A. In contrast, a system that responds to a perturbation in a way that reduces its effect is...

 loop in which prices rise dramatically above the underlying value or worth of the items. This is known as an economic bubble
Economic bubble
An economic bubble is "trade in high volumes at prices that are considerably at variance with intrinsic values"...

. Such a period of increasing speculative purchasing is typically followed by one of speculative selling in which the price falls significantly, in extreme cases this may lead to crashes
Stock market crash
A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors...

.

In 1936 John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...

 wrote: "Speculators may do no harm as bubbles
Economic bubble
An economic bubble is "trade in high volumes at prices that are considerably at variance with intrinsic values"...

 on a steady stream of enterprise
Entrepreneurship
Entrepreneurship is the act of being an entrepreneur, which can be defined as "one who undertakes innovations, finance and business acumen in an effort to transform innovations into economic goods". This may result in new organizations or may be part of revitalizing mature organizations in response...

. But the situation is serious when enterprise
Entrepreneurship
Entrepreneurship is the act of being an entrepreneur, which can be defined as "one who undertakes innovations, finance and business acumen in an effort to transform innovations into economic goods". This may result in new organizations or may be part of revitalizing mature organizations in response...

 becomes the bubble
Economic bubble
An economic bubble is "trade in high volumes at prices that are considerably at variance with intrinsic values"...

 on a whirlpool of speculation. (1936:159)" Mr Keynes himself enjoyed speculation to the fullest, running an early precursor of a hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...

. As the Bursar of the Cambridge University King's College, he managed two investment funds, one of which, called Chest Fund, invested not only in the then 'emerging' market US stocks, but also periodically included commodity futures and foreign currencies, albeit to a smaller extent (see Chua and Woodward, 1983) . His fund achieved positive returns in almost every year, averaging 13% p.a., even during the Great Depression, thanks to very modern investment strategies, which included inter-market diversification
Diversification
Diversification may refer to:* Diversification involves spreading investments* Diversification is a corporate strategy to increase market penetration...

 (i.e., invested not only in stocks but also commodities and currencies) as well as shorting, i.e., selling borrowed stocks or futures to make money on falling prices, which Keynes advocated among the principles of successful investment in his 1933 report ("a balanced investment position [...] and if possible, opposed risks.")

Volatility


According to Ziemba and Ziemba (2007), Keynes risk-taking reached 'cowboy' proportions, i.e. 80% of the maximum rationally justifiable levels (of the so called Kelly criterion
Kelly criterion
In probability theory, the Kelly criterion, or Kelly strategy or Kelly formula, or Kelly bet, is a formula used to determine the optimal size of a series of bets. In most gambling scenarios, and some investing scenarios under some simplifying assumptions, the Kelly strategy will do better than any...

), with overall return volatility
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...

 approximately three times higher than the stock market index benchmark. Such levels of volatility, responsible for his spectacular investment performance, would be achievable today only through the most aggressive instruments (such as 3:1 leveraged exchange-traded fund
Exchange-traded fund
An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...

s). He chose modern speculation techniques practiced today by hedge funds, which are quite different from the simple buy-and-hold long-term investing.

It is a controversial point whether the presence of speculators increases or decreases the short-term volatility in a market. Their provision of capital and information may help stabilize prices closer to their true values. On the other hand, crowd behavior and positive feedback loops in market participants may also increase volatility at times.

Sovereignty and food security


Some nations have moved to limit foreign ownership of cropland in order to ensure that food is available for local consumption while others have sold food land and depend on the World Food Programme
World Food Programme
The World Food Programme is the food aid branch of the United Nations, and the world's largest humanitarian organization addressing hunger worldwide. WFP provides food, on average, to 90 million people per year, 58 million of whom are children...

.

Regulating speculation


The Tobin tax
Tobin tax
A Tobin tax, suggested by Nobel Laureate economist James Tobin, was originally defined as a tax on all spot conversions of one currency into another...

 is a tax intended to reduce short-term currency speculation, ostensibly to stabilize foreign exchange.

In May 2008, German leaders planned to propose a worldwide ban on oil trading by speculators, blaming the 2008 oil price rises on manipulation by hedge funds.

On December 3, 2009, US Congressman Peter DeFazio
Peter DeFazio
Peter Anthony DeFazio is the U.S. Representative for , serving since 1987. He is a member of the Democratic Party. The district includes Eugene, Springfield, Roseburg and part of Corvallis. As Oregon's most senior member of Congress, he is the dean of Oregon's House of Representatives delegation...

 stated, "The American taxpayers bailed out Wall Street
Wall Street
Wall Street refers to the financial district of New York City, named after and centered on the eight-block-long street running from Broadway to South Street on the East River in Lower Manhattan. Over time, the term has become a metonym for the financial markets of the United States as a whole, or...

 during a crisis brought on by reckless speculation in the financial markets." He claimed a "financial transaction tax legislation will force Wall Street to do their part and put people displaced by that crisis back to work."

On January 21, 2010, President Barack Obama
Barack Obama
Barack Hussein Obama II is the 44th and current President of the United States. He is the first African American to hold the office. Obama previously served as a United States Senator from Illinois, from January 2005 until he resigned following his victory in the 2008 presidential election.Born in...

 endorsed the Volcker Rule
Volcker Rule
The Volcker Rule is a specific section of the Dodd–Frank Wall Street Reform and Consumer Protection Act originally proposed by American economist and former United States Federal Reserve Chairman Paul Volcker to restrict United States banks from making certain kinds of speculative investments that...

 which deals with speculative investments of banks that don't benefit their customers. The Volcker Rule states that these investments played a key role in the financial crisis of 2007–2010.

See also


  • Adventurer
  • Behavioral finance
    Behavioral finance
    Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...

  • Black Wednesday
    Black Wednesday
    In politics and economics, Black Wednesday refers to the events of 16 September 1992 when the British Conservative government was forced to withdraw the pound sterling from the European Exchange Rate Mechanism after they were unable to keep it above its agreed lower limit...

  • Carbon credits
  • Currency crisis
    Currency crisis
    A currency crisis, which is also called a balance-of-payments crisis, is a sudden devaluation of a currency caused by chronic balance-of-payments deficits which usually ends in a speculative attack in the foreign exchange market. It occurs when the value of a currency changes quickly, undermining...

  • Currency transaction tax
    Currency transaction tax
    A currency transaction tax is a tax placed on a specific type of currency transaction for a specific purpose. This term has been most commonly associated with the financial sector, as opposed to consumption taxes paid by consumers....

  • DeFazio financial transaction tax
  • Equity investment
  • European crime
  • Fictitious capital
    Fictitious capital
    Fictitious capital is a concept used by Karl Marx in his critique of political economy. It is introduced in chapter 29 of the third volume of Capital. Fictitious capital contrasts with what Marx calls "real capital" which is capital actually invested in physical means of production and workers, and...

  • Financial markets
  • Financial regulatory reform
  • Day trading
    Day trading
    Day trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day...

  • George Soros
    George Soros
    George Soros is a Hungarian-American business magnate, investor, philosopher, and philanthropist. He is the chairman of Soros Fund Management. Soros supports progressive-liberal causes...

  • Jesse Lauriston Livermore
    Jesse Lauriston Livermore
    Jesse Lauriston Livermore , also known as the Boy Plunger and "Great Bear of Wall Street", was an early 20th century stock trader...

  • Seasonal traders
  • Short selling
    Short selling
    In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...

  • Slippage (finance)
  • Spahn tax
    Spahn tax
    A Spahn tax is a type of currency transaction tax that is meant to be used for the purpose of controlling exchange-rate volatility. This idea was proposed by Paul Bernd Spahn in 1995.-Early history:...

  • Speculative Attack
    Speculative attack
    A speculative attack is a term used by economists to denote a precipitous acquisition of something by previously inactive speculators. The first model of a speculative attack was contained in a 1975 discussion paper on the gold market by Stephen Salant and Dale Henderson at the Federal Reserve Board...

  • Stock market bubble
    Stock market bubble
    A stock market bubble is a type of economic bubble taking place in stock markets when market participants drive stock prices above their value in relation to some system of stock valuation....

  • Stock trader
    Stock trader
    A stock trader or a stock investor is an individual or firm who buys and sells stocks in the financial markets. Many stock traders will trade bonds as well...

  • Tobin tax
    Tobin tax
    A Tobin tax, suggested by Nobel Laureate economist James Tobin, was originally defined as a tax on all spot conversions of one currency into another...

  • Tulip mania
    Tulip mania
    Tulip mania or tulipomania was a period in the Dutch Golden Age during which contract prices for bulbs of the recently introduced tulip reached extraordinarily high levels and then suddenly collapsed...

  • Volcker Rule
    Volcker Rule
    The Volcker Rule is a specific section of the Dodd–Frank Wall Street Reform and Consumer Protection Act originally proposed by American economist and former United States Federal Reserve Chairman Paul Volcker to restrict United States banks from making certain kinds of speculative investments that...


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