Whether speculation has a place in the portfolios of investors is the subject of much debate. Proponents of the efficient market hypothesis believe the market is always fairly priced, making speculation an unreliable and unwise road to profits. Speculators believe that the market overreacts to a host of variables. These variables present an opportunity for capital growth.
Some market pros view speculators as gamblers, but a healthy market is made up of not only hedgers and arbitrageurs but also speculators. A hedger is a risk-averse investor who purchases positions contrary to others already owned. If a hedger owned 500 shares of Marathon Oil but was afraid that the price of oil may soon drop significantly in value, they may short-sell the stock, purchase a put option, or use one of the many other hedging strategies.
An arbitrageur tries to capitalize on inefficiencies in the market. The newest example of this is latency arbitrage. A form of high-frequency trading, latency arbitrageurs attempt to take advantage of the time it takes quotes to travel from the stock exchanges to buyers, by placing their computers in the same data centers as stock exchange servers. Investors can profit by taking advantage of these microsecond delays.
Key Takeaways
- Speculation is the act of conducting a financial transaction that has a substantial risk of losing value but also holds the expectation of a significant gain
- Without the prospect of substantial gains, there would be little motivation to engage in speculation.
- Consider whether speculation depends on the nature of the asset, the expected duration of the holding period, or the amount of applied leverage.
- Skilled speculators understand that any short-term movements in the market are tied to world events.
- Becoming a speculator takes time and practice.
What Is Speculation?
Each of these investors is essential to an efficient and healthy market, but what is speculation and why does it attract such passionate criticism?
Economist John Maynard Keynes is one of the giants of finance. He said that speculation is knowing the future of the market better than the market itself. Instead of purchasing stock in what the investor regards as a high-quality company with long-term upside potential, the speculator looks for opportunities where significant price movement is likely. Assume that:
- Investor A purchased 300 shares of Boeing because they believed that the aviation and aerospace industry is growing rapidly. If the price of Boeing dropped tomorrow for no fundamental reason, they would likely purchase more stock because the price drop represents a better value.
- Investor B, the speculator, might sell 300 shares and exit the position altogether. If Investor B believed that Boeing was poised for a short-term price increase, then when it did not happen, they might cut their losses immediately. They may have evaluated the health and other fundamentals of Boeing but the primary metric was the anticipated short-term price movement.
Opponents of speculating believe that investing money solely based on an event that may happen in the near future is gambling. Speculators argue that they use a large amount of data sources to evaluate the market where most gamblers bet purely on chance or other less statistically significant indicators.
Is Speculating as Easy as It Seems?
Keynes went on to say that “casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of stock exchanges.” He knew in the early 20th century what statistics appear to show today. Trying to beat the market is as difficult as trying to beat a casino.
Profitable speculators often work for trading firms that provide training and resources designed to increase their odds of success. For those who speculate independently, a large amount of time is necessary to research the market, follow breaking news events, and learn and understand complicated trading strategies.
How to Speculate
The art of speculating covers a wide range of trading tactics, including pairs trading, swing trading, employing hedging strategies, and recognizing chart patterns. Speculators are often skilled at fundamental analysis, including spotting over- or under-valued companies, the amount of short interest a company holds, and analysis of earnings and other SEC statements.
Along with evaluating products, a skilled speculator knows that the short-term movements of the investment markets are largely tied to world events. For instance:
- A Middle East conflict could affect the price of oil
- A key eurozone figure could cause a violent move in the broad market indexes
- A material change in the unemployment rate could send markets soaring or plunging
The odds may be against speculators but those who make the strategy a profitable venture are highly skilled market watchers, investment product evaluators, and have the experience to read the mood of the market.
The dotcom bubble was the result of a number of issues, including speculation. Millions were invested into startup companies in the 1990s with the hopes that these companies would become profitable.
Is Speculation Appropriate for Your Portfolio?
Baby boomers close to retirement are trying a new investment strategy, according to the Los Angeles Times. Instead of the passive investment strategy that most employees use for their retirement accounts, an increasing number of people started turning to speculation in an attempt to catch up on shortfalls in their retirement accounts.
John C. Bogle, founder of The Vanguard Group, advises people to stay with long-term investing. He points out in his book, The Clash of the Cultures: Investment vs. Speculation, that beating the stock market is a zero-sum game. Attempting to beat the market with retirement funds, when the majority of traders fail, is an unwise use of money that you will later rely upon when you’re unable to work.
Most financial planners believe that speculation is only appropriate in a brokerage account using funds that aren’t essential for the daily support of yourself or your family. Before participating in speculating, pay off debt, fund your retirement account, and start a college fund, if necessary.
Regardless of how you speculate, it should be a small part of your overall investment portfolio.
Learning to Be a Speculator
Every skill takes time to learn and master. Before trading with real money, set up a virtual account through one of the many discount brokers or free websites. Learn how the market behaves and watch how your favorite stocks react to market events.
Traders cite the book, How to Make Money in Stocks by William O’Neil, as a valuable reference for learning the art of speculation. This book and many others provide aspiring traders practical tips on trading and risk management.
Finally, building a community of traders that you trust, and analyzing their trades, is a valuable resource. Consider building a list of successful traders on X (formerly Twitter) and/or Facebook. Find traders in your area and join an investing or traders club. Learning by yourself will rarely produce successful results. Take advantage of other people’s experiences and offer to share your knowledge too.
What Is Speculation?
Speculation involves investing in assets with the hope of big gains but the chance for a major loss. Investors can speculate on their positions when they make investments in a variety of assets, including stocks, real estate, and other risky ventures. Put simply, there’s usually not enough information on hand for the investor to be certain of the outcome of the investment.
Is Speculation Good or Bad in the Stock Market?
Speculation in the stock market involves making investments in assets that have a likelihood of loss. But there is the hope that the outcome will be the opposite—that there will be big gains. High-risk stocks tend to be speculative, especially penny stocks and those on the over-the-counter (OTC) market.
Speculation can be a boon and a curse for the stock market. It does provide much-needed liquidity to the market. But it can also lead to panic among investors. For instance, if speculators dump a particular stock, it may cause other investors to do the same and it may have a ripple effect on other players in the same industry.
What Are the Pros and Cons of Speculation?
Just like anything in investing, speculation comes with advantages and disadvantages. Among the major benefits, speculation creates liquidity in the market. This helps create an efficient market. It also brings attention to companies that wouldn’t otherwise fall under the radar. For instance, it provides capital to up-and-coming companies that may struggle under normal circumstances.
As for the drawbacks, speculation can lead to a massive shock in prices, especially when speculators end up buying up or selling large volumes of a particular stock. Having said that, huge price rises can attract more investors to the market, thus leading to the potential for bubbles.
The Bottom Line
Speculation is rapidly growing in popularity because of easy access to world investment markets through online brokerage portals. Because speculation is difficult to master, spend time trading in a virtual account. When you’re seeing a sustained track record of success through both up and down markets, only then should you consider speculating with real money.
The internet and financial media may encourage speculation, but that doesn’t mean you should follow the herd. Successful speculating takes a lot of skill, time, and experience to master, which most people who work outside of the financial industry don’t have. A more passive approach is likely to yield better results once dividends and long-term capital growth are considered.
