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Speculation

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Speculation, defined by the Merriam-Webster online dictionary, as it relates to markets, “is to assume a business risk in hope of gain; […] to buy or sell in expectation of profiting from market fluctuations.”[1]. It can be divided into two distinct categories. Long-term speculation is when an investor buys an item (commodity, security instrument, etc.) and holds it, in the hopes of its value increasing over time. Short-term speculation is done by those who anticipate a given item’s price to fall. In most cases long and short speculation is done by the same actors[2].

Speculation vs. Investment[edit]

As the great dean of security analysis, Benjamin Graham, once noted, "The difference between investment and speculation is understood in a general way by nearly everyone, but when we try to formulate it precisely, we run into perplexing difficulties. In fact something can be said for the cynic's definition that an investment is a successful speculation and a speculation an unsuccessful investment."

The common dictionary definition of speculation is that a speculation is an investment in a risky business venture with the potential for large gains (or losses). This seems an acceptable definition for everyday informal use with the connotation of risk being the key distinction between speculation compared to investment, where investment is perceived as safer. Yet risk is often in the eye of the beholder. What may seem risky to me may not seem risky at all to you. Investing in an Internet stock seems risky to me, but it may seem less risky for those involved in the business, who understand the technology and industry better than I do. A man with tens of millions can prudently take risks that a man living pay to pay check probably should not.

If we are going to talk about the economic role of the speculator and see speculation as it is, we would do well to distill it of its connotation of excess risk, since this risk is not objectively determinable for everyone. While there are many ways to quantitatively measure risk, ultimately the future is unknowable. Risk is always defined from one's specific point of view.

Realizing this, Carret defines speculation thusly: "Pure speculation involves buying and selling in the same market without rendering any service in the way of distribution, storage and transportation". A man who buys a crate of eggs to distribute to consumers a dozen at a time at a price a few cents higher does not engage in speculation. Although, the merchant may earn a speculative profit should the price of eggs rise before he sells them. Here the merchant performs several services; he likely must store the eggs, transport and distribute them. He earns his way by adding value through these services, services that consumers are willing to pay for. However, the price of eggs fluctuates still, due to reasons not directly influenced by our small egg merchant. It is these fluctuations, Carret believed, that may be said to be speculative. In this sense, the everyday merchant cannot help but engage in speculation as a matter of course. The egg merchant must be aware of, and must deal with, the fluctuating price of eggs.[3]

Speculation vs. gambling[edit]

There is an important distinction between the gambler and speculator. The speculator, Grant maintains, bears risks that come into existence prior to the speculator's decision to bear it. "Thus, the risk of falling cotton prices antedated the decision of the cotton speculator to enter the futures market. In a world without speculators, every farmer would have to hedge his or her own crops, every banker his or her own securities, and every insurer his or her own promises to underwrite the next disaster. In gambling, no risk of loss existed before a casino patron sits down to try his luck. The risk borne by the gambler, like that by the skier, is created specifically by the participant for the occasion."[3]

Speculators[edit]

Speculators are often vilified in public discourse and blamed for increasing prices. However, it is the speculator who assumes great risk, and this exchange helps to maintain inventory; as a result, speculators are benefactors of society.

In short, they buy low when a surplus exists, hold, and then sell when the price increases due to higher consumer demand. The newly introduced product from the speculator will tend to reduce prices again. Meanwhile, producers continue operations, thereby ensuring that enough is available to meet future demand. Without a speculator providing incentives to producers, shortages and rapid price fluctuations can occur. All actors would find it difficult to plan in such an environment, and resources would be frequently misallocated[4].

For those who subscribe to the notion that speculators are the cause of rising prices, as opposed to inflation, controlling speculation is seen as the answer. In the summer of 2011, a contingent of US Senators, lead by Bernard Sanders, introduced legislation meant to curtail oil speculating, thought to be responsible for dramatic increases in gasoline prices. Sen. Sanders wrote that his bill would “establish speculative oil position limits […] and double the margin requirements on speculative oil trading…[5].” As of September of 2011, the legislation has not been passed into law.

Services provided by the speculator[edit]

The primary services that speculators provide are to assume risks, to speed market adjustments and to provide liquidity. In these ways, speculators help the market (or whatever specific sub-market one chooses to define) function more efficiently.[3]

The successful speculator — who can consistently buy low and sell high — can predict certain stock prices better than others, and indeed even better than others who are risking money on those very stocks. For example, if a speculator buys at $100 on Monday and sells at $110 on Friday, he was only able to do this because other people in this very market didn't realize on Monday that the stock would appreciate so quickly. (If they did, they wouldn't have sold for $100. They would have held onto the stocks and netted the gain themselves.)

If this were the whole story, then stock speculation might truly be a zero-sum game, where the lucky or farsighted enrich themselves at the expense of the unlucky or dimwitted. This isn't the case, however, because in the very process of profiting from their superior vision, stock speculators influence stock prices. When stock prices are undervalued, the successful speculator buys shares, an action that drives up the prices in question. In contrast, if a stock is "overvalued" — and by this term we mean nothing deeper than that the stock will fall in price more quickly than others in the market realize — then the successful speculator may "short sell" it, or engage in comparable actions (such as buying a put option) that tend to push down the share price.

In the aggregate, we have thousands or even millions of professionals who study the stock market from every conceivable angle, looking at both political events and fundamental data on individual companies. Consequently, new information is quickly incorporated into expectations and finds its expression in updated stock prices. Although some Chicago economists take this notion of the "efficient (stock) market" too far, it is certainly true that individual efforts to make a buck foster a mind-boggling nexus of analysis and communication.[6]

It is in this buying and selling that speculators help to better allocate resources to their highest uses. As Carret articulated it, speculators do so by "opening reservoirs of capital to the growing enterprise, shutting of the supply of capital from enterprises which have not profitably used that which they already possess." In this respect, the speculator is an "advance agent" directing capital to its highest uses.

The speculators also absorb risk. For example, the speculator may sell cotton futures. The buyer of these futures may be a mill who wishes to lock-in a price now for cotton, thereby protecting itself against the risk that prices rise. The speculator here assumes some of that risk.

Or, perhaps, "…the speculator is a buyer – for instance, a Tunica cotton farmer. The farmer is occupationally bullish, but he is also realistic, and he sees that the price of cotton for October delivery is well above his cost of production. It is now the Fourth of July, and long weeks of uncertainty stand between him and his harvest. By selling forward an unharvested portion of his crop, he is able to lock in a profitable price. This he does with the self-interested help of the speculator."

It is shown in these examples that the buyer and seller are not typically antagonistic. The mill and cotton farmer are able to lock-in prices now and reduce the risk of uncertain future prices. The speculator stands to profit if the speculator's estimation of the future market is right.

Finally, the presence of speculators provides liquidity for a market. Liquidity is the degree to which an asset or good can be converted into cash. Stocks and bonds and many other financial assets are very liquid assets precisely because there are many speculators willing to buy and sell these securities. Without a stable of ready buyers and sellers, it would be difficult to convert investments into cash quickly at prices that reflect market values.[3]

Speculation, bubbles and crashes[edit]

Speculators, as defined, represent no threat to an economy. On the contrary, the speculator provides useful services that improve the efficiency of the market. But what of the spectacular bubbles and crashes of years gone by? Aren't they caused by excessive speculation?

These historic events, such as the crash of '87, or the S&L crisis, or the great crash of '29, should each be treated as unique occurrences. Each had its own seeds, so to speak. Speculation itself does not cause crises, however. Instead, speculation reveals quickly the underlying weaknesses in a market and affirm the buying public's approval or disapproval. The currency collapses of many Asian nations in 1998 revealed concrete weaknesses in the economic and political environment and were not caused by speculation. The Austrian school of economics has famously argued that credit expansion and intervention bring on the boom-bust cycle, and that the boom-bust cycle is not endogenous to the market system. Further, government can often create an environment that encourages risk taking. The existence of Federal Deposit Insurance Corporation and government bailouts of failing firms changes the behavior of market participants. The FDIC weakens depositor discipline on financial institutions, for example, and keeps poor performers in business when they should have closed their doors.

The point is that speculation itself, the mere buying and selling for profit, is not an evil. It is a necessary component of a fluid efficient market. Moreover, human beings are not omniscient and opinion can change quickly, especially in financial markets. Great collapses can be brought on by errors in judgment that are revealed only after they have occurred. No one can predict what the future state of a market will look like.[3]

References[edit]

  1. "Speculation". Merriam-Webster. Accessed 09-21-2011
  2. .Reference[1] Speculation. Encyclopedia Britannica. Accessed 09-21-2011
  3. 3.0 3.1 3.2 3.3 3.4 Christopher Mayer. "Speculation", Mises Daily, October 25, 1999. Referenced 2011-09-22.
  4. .Reference[2] Walter Block. Chapter 7 - Defending the Undefendable
  5. .Reference[3] The Huffington Post. Stop Oil Speculation Now. Sanders, Bernie Accessed 09-21-2011
  6. Robert P. Murphy. "The Social Function of Stock Speculators", Mises Daily, November 22, 2006. Referenced 2011-09-22.

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