Speculation

By: EconomyWatch   Date: 23 November 2010

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Speculation refers to making financial decisions by assuming the risk of loss for the potential for increased returns. There is really a very thin line of difference between speculation and investment and between a speculator and an investor. While all investors must speculate (albeit at different degrees), all speculators must invest in order to make profits.

 

The Difference Between Investment and Speculation

The difference between an investor and a speculator can be seen vis-à-vis the following parameters:

  • Holding period: While an investor usually has a longer planning horizon and holds the investment for at least a year, a speculator holds the investment for a few days or months.

 

  • Risk disposition: While an investor takes on moderate risks, a speculator assumes significantly higher risk.

 

  • Expectation of returns: An investor expects moderate returns, while a speculator makes investments that promise high returns.
  • Decision making: An investor would carefully evaluate the factors impacting the investment. A speculator would depend more on tips and market sentiments.

 

How Speculation Yields Returns

The degree of speculation tends to rise when the economy is bullish and the markets are buoyant. This is how bubbles are created. A bubble is a phenomenon during which the value of an investment (such as real estate, stock, foreign exchange and petroleum futures) rises substantially. Most of the investments are overpriced in such a scenario, yielding high returns.

 

Speculation: Dangers

A speculative buying spree, devoid of analytical calculation, aggravates the element of risk. Any downturn in prices can cause panic and excessive selling, resulting in a dramatic plummeting of prices and eventually a market crash. The stock market crisis of2008 can be attributed to consecutive periods of speculative buying, followed by panic and speculative selling.

How Speculation Helps the Market

Speculation can be a blessing for the economy. This is because speculators inject capital in the market, thereby increasing liquidity. Speculative investments also minimize the risk for arbitrageurs and hedgers.

Benjamin Graham (author of the classic books Security Analysis and The Intelligent Investor and mentor to Warren Buffett) urged people to ignore the market as a whole and focus on the true “value” represented by an investment.


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