speculation

 

practice of engaging in business in order to make quick profits from fluctuations in prices, as opposed to the practice of investing in a productive enterprise in order to share in its earnings. The term is sometimes applied to investment in a venture involving abnormal risks along with the chance to earn unusually large profits, but most speculation consists in the buying and selling of commodities and stocks and bonds with the object of taking advantage of rapid changes in price. While the investor seeks to protect his principal as it yields a moderate return, the speculator sacrifices the safety of his principal in hopes of receiving a large, rapid return. The practice is defended as tending to stabilize prices and guide investment; it is attacked as the mechanism of financial crisis and panic when prices decline rapidly and as an inflationary factor when a commodity is in shortage and speculation drives up its price.

Public outcry over speculation has had an important political impact in several periods of U.S. history. During the progressive era in the late 19th and early 20th cent., speculation on Wall Street helped reformers led to landmark legislation regulating big business. Following the crash of 1929, which was widely blamed on the speculative abuses of the 1920s, the Roosevelt administration passed legislation regulating Wall Street and the banking industry. In the 1980s and early 1990s, critics attacked junk bonds, corporate mergers, and the savings and loan industry as examples of speculative abuses that reduced America's economic competitiveness. In the late 1990s speculation was most evident in the enormously high market value attained by some Internet and computer company stocks and in the on-line day trading of stocks.

See also banking; margin requirement; panic.

Bibliography

See R. Sobel, Panic on Wall Street (1968); M. Mayer, Markets (1988); C. Kindleberger, Manias, Panics, and Crashes (1989); E. Chancellor, Devil Take the Hindmost (1999); G. J. Millman, The Day Traders (1999); C. R. Morris, Money, Greed, and Risk (1999); R. J. Shiller, Irrational Exuberance (2000).

Financial market participants

Investors

Speculators speculation

Institutional investors Insurance companies Investment banks Hedge funds Mutual funds Pension funds Private equity funds Venture capital funds Banks Credit Unions Trusts Prime Brokers

Finance series Financial market Participants Corporate finance Personal finance Public finance Banks and Banking Financial regulation

Speculation, in the narrow sense of financial speculation, involves 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 as opposed to buying it for use or for income via methods such as dividends or interest. Speculation or agiotage represents one of three market roles in Western financial markets, distinct from hedging, long- or short-term investing, and arbitrage.

Speculation areas

Convention, and especially satire, sometimes portray speculators comically as speculating in pork bellies (in which a real market and real speculators exist) and often "losing their shirts" or making a fortune on small market changes. Speculation exists in many such commodities, but, if measured by value, the most important markets deal in futures contracts and other derivatives involving leverage that can transform a small market movement into a huge gain or loss.

Type of speculators

Most non-professional traders lose money on speculation, while those who do make money tend to become professionals. Occasionally some dramatic event will occur, such as the effort of the Hunt brothers to corner the silver market or the currency speculations of George Soros or the speculative trading of Nick Leeson, which caused the collapse of Barings Bank.

By some definitions, most long-term investors, even those who buy and hold for decades, may be classified as speculators,^{[citation needed]} excepting only the rare few who are not primarily motivated by eventually selling at a good profit. Some dedicated speculators are distinguished by shorter holding times, the use of leverage, by being willing to take short positions as well as long positions (in markets where the distinction can be reasonably made). 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."

In Security Analysis, Benjamin Graham gave a definition of speculation in relation to investment: "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

The economic benefits of speculation

The service provided by speculators to a market is primarily 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 (pig 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 will 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.

Another example of the value of speculators is the ability of a pig farmer to sell his pork on a futures exchange at a known price ahead of its production.

Some side effects

Auctions are a method of squeezing out speculators from a transaction, but they 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.

Speculative purchasing can also create inflationary pressure, causing particular prices to increase 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. Overall, the participation of speculators in financial markets tends to be accompanied by significant increase in short-term market volatility. This is not necessarily a bad thing, as heightened level of volatility implies that the market will be able to correct perceived mispricings more rapidly and in a more drastic manner.

Etymology

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. Speculate is a 1599 back-formation.

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 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.

Books

• Sobel, Robert [1973] (2000). 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. 

See also

• Behavioral finance
• Equity investment
• Fictitious capital
• Financial markets
• Day trading
• Jesse Lauriston Livermore
• Gambling
• Seasonal traders
• Short selling
• Speculative Attack
• Stock market bubble
• Stock trader
• Tobin tax
• Tulip mania

Stock market
Types of stocks	Stock · Common stock  · Preferred stock  · Outstanding stock · Treasury stock
Participants	Market maker · Floor trader · Floor broker
Exchanges	Stock exchange · List of stock exchanges
Stock valuation	Gordon model · Dividend yield · Income per share · Book value · Earnings yield · Beta coefficient
Financial ratios	P/CF ratio · PE ratio · PEG ratio · Price/sales ratio · P/B ratio · D/E ratio · ROIC · ROE
Trading theories	Dow Theory · Elliott Wave Theory  · Fundamental analysis · Technical analysis · Mark Twain effect · January effect · Efficient market hypothesis · Arbitrage pricing theory
Related terms	Dividend · Stock split · Growth stock · Investment · Speculation · Trade · Day trading

Donate to Wikimedia