Speculation Series – Part I
Speculation is one of the most important concepts that every investor must understand. However, like selling, it is also a topic that is rarely covered in personal finance books. On the other hand, many investors do not understand the difference between speculating and investing. At no other time in our living history has this been more evident than it has been in the last 2 years. There was/is speculation in everything from Stocks (Stonks) to Crypto and NFTs. Personally, I find this topic (of speculation) fascinating and thus dedicating an entire series of interesting posts to it. However, unlike the “On Selling Out” series, I will be writing a post on this topic every month rather than one after the other. The first post in the series defines (and explains) speculation, speculator and the difference between speculation and investing.
First things first, let’s begin with the meaning of the word speculation and speculator.
According to Edward Chancellor, Author of Devil Take the Hindmost, “Speculation acquired an economic meaning in the late eighteenth century and even then, it was a curiously imprecise term. In a letter dated 1 May 1774, Horace Walpole described Sir George Colebrook, the MP and banker, as a martyr to what is called as speculation, after Colebrook was bankrupted in a failed attempt to corner the market for alum, a substance used in the dyeing of textiles. Two years later, Adam Smith in the book The Wealth of Nations referred to the sudden fortunes that “are sometimes made by what is called the trade of speculation.”
Yet Smith’s speculative merchant was not a financial operator but an entrepreneur who exercises no one regular, established, or well-known branch of business. He is a corn merchant this year, or tea merchant the year after. He enters into every trade when he foresees that it is likely to be more profitable than commonly profitable, and he quits when he foresees that its profits are likely to return to the level of other trades. For Smith, the speculator is defined by his readiness to pursue short term opportunities for profit: his investments are fluid whereas those of the conventional businessman are more or less fixed.
Speculation has come to mean different things to different people, yet it retains something of its original philosophical meaning; namely to reflect or theorize without a firm factual basis. According to a seventeenth century definition, a speculator is one who indulges in occult observations or studies. The financial speculator still resembles the alchemist in that he is constantly constructing abstruse theories to turn normal paper into gold, normally with little success. Occasionally, investors consult astrological tables or spiritual mediums to enhance performance. Did you know even today, in New York, there exists an Astrologers Fund whose manager promises stellar returns?
If you don’t believe me, google “Astrologers Fund.”
Now that we have got some heavy-duty definitions out of the way, let’s aim for a simple one.
To put it simply, speculation is nothing but an attempt to profit from changes in market price. According to the Austrian economist Joseph A Schumpeter, “the difference between a speculator and investor can be defined by the presence or absence of the intention to trade, i.e., realize profits from the fluctuations in security prices.”
According to Financial Times, Blackrock, the world’s largest asset manager, has taken a $17 billion in losses on its Russian securities holdings because of the war on Ukraine (rather the accompanying worldwide sanctions). The asset manager marked down the value of its largest Russian exchange traded fund ERUS from $600 million at the end of 2021 to a value of less than $1 million as the vast majority of securities were unsaleable (courtesy – worldwide sanctions). A markdown of more than 99%. This is an ideal playground for speculators. Some of them would love to buy these securities. Blackrock however has suspended all purchases.
In early 2020, reactions to COVID-19 pandemic led to steep declines in global petroleum demand and world oil prices. As demand fell and US crude oil inventories went up, West Texas Intermediate (WTI) crude oil traded at negative prices on April 20th, the first time the price for the WTI futures contract fell to less than zero, since trading began in 1983. The next day, Brent Crude, another global oil price benchmark, fell to $9.12 per barrel, its lowest price in decades. This is one more example of a great opportunity for speculators.
However not all speculation opportunities are like the ones above. I mean the fluctuations in prices are not as deep and these come about once or twice in a decade when shit has hit the roof. Hence to maximize (or magnify) returns, most speculators use leverage (in simple terms – borrow money) to invest or go for leveraged investments. Leverage can magnify your returns or magnify your losses to zero. This (practically zero) is what investors in a Bull 2X Russian ETF will get when the fund liquidates on March 18th. A $100,000 investment in this ETF when it debuted in March 2011 is now just worth $180.
$180. Pretty close to Zero.
Investing on the other hand follows a very different curve.
While the sketch above explains the difference between investing and speculation, it would pay rich dividends to understand this as a long-term investor.
This is because speculation is exciting, full of breath-taking ups and downs. If you chart it over time, it almost looks like your heartbeats.
Investing on the other hand is slow and boring. In the short term, there will be ups and downs (will be sharing some insightful data next week – watch out for this), but if you chart investing over time, it exactly looks like a compounding curve. It is like watching grass grow.
I end the first part with some powerful insights from Edward Chancellor. Fred Schwed, a Wall Street wit, concluded that investing and speculation could be separated on the grounds that the first aim of investment was the preservation of capital while the primary aim of speculation was the enhancement of fortune. As Fred put it: Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investment is an effort, which should be successful to prevent a lot of money from becoming a little.