4/14/2023

Speculation • The main difference between speculating and investing

is the amount of risk undertaken in the trade.

versus
• Typically, high-risk trades that are almost akin to
gambling fall under the umbrella of speculation,
whereas lower-risk investments based on fundamentals
and analysis fall into the category of investing.

Investment • Investors seek to generate a satisfactory return on their

capital by taking on an average or below-average
amount of risk.
• On the other hand, speculators are seeking to make
abnormally high returns from bets that can go one way
or the other.

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Speculation is Not
Gambling Example of Speculation
• It should be noted that speculation is not exactly • As an example of a speculative trade, consider a
like gambling because speculators do try to make volatile new gold mining company that has an
an educated decision on the direction of the trade, equal chance over the near term of skyrocketing
but the risk inherent in the trade tends to be from a new gold mine discovery or going bankrupt.
significantly above average. • With no news from the company, investors would
tend to shy away from such a risky trade, but some
speculators may believe that the junior gold mining
company is going to strike gold and may buy its
stock on a hunch. This would be speculation.

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Example of Investing
• As an example of investing, consider a large stable • Benjamin Graham, along with David Dodd,
multinational company. The company may pay a attempted a precise definition of investing and
consistent dividend that increases annually, and its speculation in their seminal work Security Analysis
business risk is low. (1934). “An investment operation is one which, upon
• An investor may choose to invest in this company thorough analysis, promises safety of principal and
over the long-term to make a satisfactory return on a satisfactory return. Operations not meeting these
his or her capital while taking on relatively low risk. requirements are speculative.”
• Additionally, the investor may add several similar
companies across different industries to his or her
portfolio to diversify and further lower their risk.

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• In John Maynard Keynes' famous work 'General Theory • All market activity lies on a time continuum. Moving
of Employment, Interest, and Money (1936),' is a chapter from left to right, we observe buy–sell decisions in
titled “The State of Long Term Expectation.” Here, Keynes the stock market that occur in microseconds,
got right to the point, deciding to “appropriate the term minutes, hours, days, weeks, months, years, and
speculation for the activity of forecasting the psychology
decades.
of the market, and the term enterprise [a word he used
for investment] for the activity of forecasting the • Although it is unclear exactly where the
prospective yield of assets over their whole life.” demarcation line is located, it is generally agreed
• It is the same point that is driven home 75 years later by that activity occurring on the left side of the time
John Bogle in his book 'The Clash of the Cultures: continuum is more likely to be speculation, whereas
Investment vs. Speculation (2012).' In Bogle’s opinion, activity residing on the right side is thought to be
investment means long-term ownership whereas investing.
speculation is more short-term trading.

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Speculators Contribute to
Is speculation bad? the Liquidity of the Markets
• Academic research clearly demonstrates that the • Lynn Stout, Distinguished Professor of Corporate and
market benefits from, and is optimized by, the Business Law at Cornell Law School, in “Uncertainty,
participation of both investors and speculators. Dangerous Optimism, and Speculation: An Inquiry
• Although some investment purists might vote for into Some Limits of Democratic Governance”
opening the stock market just one day each year argued that a speculator that provides insurance
and on that day all buyers and sellers would and liquidity for the risk-averse farmer who wishes to
transact business, the lack of daily liquidity would enter into a forward contract to sell his wheat at
likely do more harm than good for the capital today’s price deliverable next month “fits the
markets. standard economic model of mutually beneficial
exchange that improves the welfare of both trading
parties.”

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Speculators help Share Prices

• All this implies that speculators (speculation) Reach their Fair Values
contribute significantly to the liquidity of the
• In addition to risk hedging and liquidity dealing,
markets.
Milton Friedman told us that speculators who
practice what is today called “information theory
arbitrage” should be thought of as talented
researchers who work aggressively to close the
price–value gap.
• Carret shared the same opinion. He wrote: “The
speculator is looking for hidden weak spots in the
market,” and as such, acts as “the advance agent
of the investor, seeking always to bring market
prices into line with investment values.”

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