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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.[1] Speculation typically involves the lending of money or the purchase of assets, equity or debt 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 and Dodd'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.[2]

In a financial context, the terms "speculation" and "investment" are actually quite specific. For instance, although the word "investment" is typically used, in a general sense, 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 actually 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, economic factors associated with market timing, 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 in certain commodities, such as oil and gold, is, by definition, speculation. Short selling is also, by definition, speculative.

Financial speculation can involve the buying, holding, selling, and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives, or any valuable financial instrument to profit from fluctuations in its price, irrespective of its underlying value.

Contents

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."[3] 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.

Speculators can be increasingly distinguishable by shorter holding times, the use of leverage, by being willing to take short positions as well as long positions. A degree of speculation exists in a wide range of financial decisions, from the purchase of a house to a bet on a horse; this is what modern market economists call "ubiquitous speculation."

The economic benefits of speculation

The well known speculator Victor Niederhoffer, in "The Speculator as Hero"[4] 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 in the hope of profit, they add liquidity to the market and make it easier for others to offset risk, including those who may be classified as hedgers and arbitrageurs.

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 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, thus creating a more efficient market.

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.

Some side effects

Auctions are a method of squeezing out speculators from a transaction, but they may have their own perverse effects; see winner's curse. 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.

Speculation can also cause prices to deviate from their intrinsic value if speculators trade on misinformation, or if they are just plain wrong. For example, speculative purchasing can push prices above their true value (real value - adjusted for inflation) simply because the speculative purchasing artificially increases the demand. Speculative selling can also have the opposite effect, causing prices to artificially decrease below their true value in a similar fashion. In various situations, price rises due to speculative purchasing cause further speculative purchasing in the hope that the price will continue to rise. This creates a positive feedback loop in which prices rise dramatically above the underlying value or worth of the items. This is known as an economic bubble. 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.

In 1936 John Maynard Keynes 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. (1936:159)"[5]

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.

Finance

The Etymology of the word is as follows; from O.Fr. speculation, from L.L. speculationem (nom. speculatio) "contemplation, observation," from L. speculatus, pp. of speculari "observe," from specere "to look at, view". Speculator in the financial sense is first recorded 1778.

What is significant to note is the change from a passive to an active form of use. Specifically from a strict observer to one who contemplates what they observe then further to one who contemplates and acts on what they observe.

With these changes, the word as now commonly used, describes one who observes an object, event, or situation and takes some form of action with regard to the observed, all the while aware they may not know all the facts or factors regarding or affecting that which they observe. E.g. the financial speculator, one who understands and accepts he may not know all the facts or risks involved with a venture, yet chooses to invest his capital in the venture for the possibility of receiving greater capital in return.

Regulating Speculation

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

In May 2008, German leaders have planned to propose a worldwide ban on oil trading by speculators, blaming the 2008 oil price rises on manipulation by hedge funds.[6]

Books

  • Sobel, Robert (2000) [1973]. The Money Manias: The Eras of Great Speculation in America, 1770-1970. Beard Books. ISBN 1-58798-028-2.  
  • Gunther, Max (1992). The Zurich Axioms. Souvenir Press. ISBN 0-285-63095-4.  
  • Niederhoffer, Victor (2005). Practical Speculation. Wiley. ISBN 0-471-67774-4.  

References

  1. ^ Graham, Benjamin, and David Dodd (1951). Security Analysis. McGraw-Hill Book Company. ISBN 0071448209.
  2. ^ Graham, Benjamin, and David Dodd (1951). Security Analysis. McGraw-Hill Book Company. ISBN 0071448209.
  3. ^ Graham, Benjamin (1973). Intelligent Investor. HarperCollins Books. ISBN 0060555661.
  4. ^ Victor Niederhoffer, The Wall Street Journal, February 10, 1989 Daily Speculations
  5. ^ Dr. Stephen Spratt of Intelligence Capital (September 2006). "A Sterling Solution". Stamp Out Poverty report. Stamp Out Poverty Campaign. p. 15. http://www.stampoutpoverty.org/?lid=9889. Retrieved 2010-01-02.  
  6. ^ Evans-Pritchard, Ambrose (May 26, 2008). "Germany in call for ban on oil speculation". The Daily Telegraph (The Daily Telegraph). http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/05/26/cnoil126.xml. Retrieved 2008-05-28.  

See also

External links


Quotes

Up to date as of January 14, 2010
(Redirected to Investment article)

From Wikiquote

Sourced

  • The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There's a problem, though: They are dancing in a room in which the clocks have no hands.
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1911 encyclopedia

Up to date as of January 14, 2010

From LoveToKnow 1911

SPECULATION, a round game of cards at which any reasonable number can play. Each player contributes a stake to the pool, the dealer staking double. Three cards are dealt face downwards to each player; the top card of those left is turned up for trumps. Each player, beginning with the player on the dealer's left, turns up a card; if it is not a trump, or is a lower trump than the trump-card, the next player turns up one of his cards, and so on till a higher trump than the trump-card appears, the values being reckoned as at whist. The holder may sell this card to the highest bidder, or retain it. The turning-up proceeds till a still higher trump is found, but the holder of the original highest does not turn up till his card is beaten. The new card may then be sold. The dealer may not turn up till the trump-card has been beaten. The holder of the highest trump when all the hands have been exposed takes the pool. If the ace of trumps is the trump-card, the dealer takes the pool; if it is turned up during play, the hand is, of course, at an end. Variations of the game allow the purchase of unseen cards or hands, or of the trump-card, even before it is turned up. The cards used in one deal are not dealt again till the whole pack has been gradually dealt out; they are collected and shuffled by the "pone" - the player on the dealer's right - to be used when the pack is exhausted.


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Simple English

The English Wiktionary has a dictionary definition (meanings of a word) for:

Speculation has a special meaning when talking about money. The person who speculates is called a speculator. A speculator does not buy goods to own them, but to sell them later. The reason is that he wants to profit from the changes of market prices.

One tries to buy the goods when they are cheap and to sell them when they are expensive. There is a good chance to do that as long as the market price of a good changes often in different directions.

Speculation includes the buying, holding, selling, and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives or any valuable financial instrument. It is the opposite of buying because one wants to use them for daily life or to get income from them (as dividends or interest).

Speculation is one of the market roles in western financial markets. The others are hedging, long term investing and arbitrage. Speculators do not plan to keep an asset for a long time.[1]

References

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