Business, Legal & Accounting Glossary
Speculation is a risky bet that could have a large payoff if it works out. The speculative investor attempts to profit from the price fluctuations of real estate, commodities, stocks, or any other type of investment that stands to churn out a profit.
Speculation, in the narrow sense of financial speculation, involves the buying, holding, selling, and short-selling of stocks, bonds, commodities, currencies, collectables, 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.
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.
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, 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 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.
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 a significant increase in short-term market volatility. This is not necessarily a bad thing, as a heightened level of volatility implies that the market will be able to correct perceived mispricings more rapidly and in a more drastic manner.
The word “speculate” comes from the Latin word speculatus, which is the past participle of speculari , meaning to look ahead, to spy, and to examine. The word speculari derives from the name specula, from specere “to see”, who was the Roman legionary that watch the legion’s camp known as castrum. In this word we find the etymological significant of the contemporanean word, that implies the activity of looking at distant things, in the space and also in the time. From “specula” derive in late Latin the word “speculatio, speculationis”, the activity of philosophical enquiring. The word is used now with this sense in philosophy, as the activity of theorizing without a solid factual base, as the modern financial speculator who take position in the market without a solid statistical base.
Will your house be worth more in five years than is now? Will the prices of milk and eggs finally come back down to Earth? And what about those pork bellies, anyway?
No one knows for sure where prices will go, but speculators will do their very best to profit from guessing (speculating). Whether it’s real estate, commodities, stocks, options, currencies, or any other investment that stands to crank out a profit, these folks will take long and short positions based on whether they think prices will move up or down.
The difference between this type of investing and, say, value investing is that speculation focuses on price fluctuations — not on whether a company sells a popular product, boasts a solid balance sheet, or has a savvy management team. And again, it doesn’t pertain to just stocks. Most new housing developments include “spec” homes, for instance. These houses are being built without a signed purchase agreement in anticipation that buyers will arrive later.
Another common example in the United States is land speculation. There is only so much land, so speculators assume that its value will gradually increase. The investment becomes more palatable when the property generates enough cash to pay property taxes and likely maintenance costs — timberland is attractive because the trees can be harvested to provide income, as is farmland when it’s suitably productive. AllRight Auto Parks (now long ago acquired) made yet another type of land speculation when it snatched up vacant plots in downtown regions of several cities and turned them into parking lots, all while waiting for a developer to come around and pay its price.
One of the big draws with speculation is that investors typically stand to make large sums of money if things go in their favor — buy a home in an “up and coming” neighborhood, and you might just earn yourself with a windfall when you sell it a few years later. On the other hand, speculation also brings high risks – just ask the folks who bought oil for $145 per barrel in the summer of 2008, not long before it dropped to below $40.
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This glossary post was last updated: 28th November, 2021 | 0 Views.