In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum.^[1] Speculation typically involves the lending of money or the purchase of assets In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset. Simplistically stated, assets represent ownership of value that can be converted into cash . The balance sheet of a firm, equity The stock or capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors. Stock is distinct from the property and the assets of a business which may fluctuate in or debt In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals but in a manner that has not been given thorough analysis or is deemed to have low margin of safety Another definition: In Break even analysis , margin of safety is how much output or sales level can fall before a business reaches its breakeven point or a significant risk of the loss of the principal investment. The term, "speculation," which is formally defined as above in Graham Benjamin Graham was an American economist and professional investor. Graham is considered the first proponent of Value investing, an investment approach he began teaching at Columbia Business School in 1928 and subsequently refined with David Dodd through various editions of their famous book Security Analysis. Disciples of value investing include and Dodd David LeFevre Dodd was an American educator, financial analyst, author, economist, professional investor, and in his student years, a protégé of, and as a postgraduate, close colleague of Benjamin Graham at Columbia Business School. He attended the University of Pennsylvania's 1934 text, Security Analysis, contrasts with the term "investment," which is a financial operation that, upon thorough analysis, promises safety of principal and a satisfactory return.^[1]

In a financial context, the terms "speculation" and "investment" are actually quite specific. For instance, although the word "investment" is typically used, in a general sense, to mean any act of placing money in a financial vehicle with the intent of producing returns over a period of time, most ventured money—including funds placed in the world's stock markets—is actually not investment, but speculation.

Speculators may rely on an asset appreciating in price due to any of a number of factors that cannot be well enough understood by the speculator to make an investment-quality decision. Some such factors are shifting consumer tastes, fluctuating economic conditions, buyers' changing perceptions of the worth of a stock security A security is a fungible, negotiable instrument representing financial value. Securities are broadly categorized into debt securities and equity securities, e.g., common stocks; and derivative contracts, such as forwards, futures, options and swaps. The company or other entity issuing the security is called the issuer. A country's regulatory, economic factors associated with market timing Market timing is the strategy of making buy or sell decisions of financial assets by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis. This is an investment strategy based on the outlook for an aggregate market, rather, the factors associated with solely chart-based analysis, and the many influences over the short-term movement of securities.

There are also some financial vehicles that are, by definition, speculation. For instance, trading commodity Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts futures contracts In finance, a futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality at a specified future date at a price agreed today . The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They, such as for oil and gold, is, by definition, speculation. Short selling is also, by definition, speculative.

Financial speculation can involve the buying, holding, selling Trade is the voluntary exchange of goods, services, or both. Trade is also called commerce or transaction. A mechanism that allows trade is called a market. The original form of trade was barter, the direct exchange of goods and services. Later one side of the barter were the metals, precious metals , bill, paper money. Modern traders instead, and short-selling In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to the lender. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as of stocks The stock or capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors. Stock is distinct from the property and the assets of a business which may fluctuate in, bonds In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals, commodities A commodity is a good for which there is demand, but which is supplied without qualitative differentiation across a market. It is fungible, i.e. equivalent no matter who produces it. Examples are petroleum, notebook paper, milk or copper. The price of copper is universal, and fluctuates daily based on global supply and demand. Stereo systems, on, currencies In economics, the term currency can refer to a particular currency, for example Pound Sterling, or to the coins and banknotes of a particular currency, which comprise the physical aspects of a nation's money supply. The other part of a nation's money supply consists of money deposited in banks , ownership of which can be transferred by means of, collectibles A collectable or collectible is typically a manufactured item designed for people to collect. In this respect, they are distinguishable from other subjects of collections, which may also include natural objects and objects manufactured for purposes other than collecting (e.g., stamps). Some objects designed for other purposes, such as toys, become, real estate Real estate is a legal term that encompasses land along with improvements to the land, such as buildings, fences, wells and other site improvements that are fixed in location—immovable. Real estate law is the body of regulations and legal codes which pertain to such matters under a particular jurisdiction and include things such as commercial, derivatives A derivative, in non-financial-expert terms, is an agreement or contract that is not based on a real, or true, exchange, i.e.: There is nothing tangible like money, or a product, that is being exchanged. For example, a person goes to the grocery store, exchanges a currency for a commodity (say, an apple). The exchange is complete, both parties, or any valuable financial instrument Alternatively, financial instruments can be categorized by "asset class" depending on whether they are equity based or debt based (reflecting a loan the investor has made to the issuing entity). If it is debt, it can be further categorised into short term (less than one year) or long term to profit from fluctuations in its price, irrespective of its underlying value.

In architecture speculation is used to determine works that show a strong conceptual and strategic focus.^[2]

Investment vs. speculation

Identifying speculation can be best done by distinguishing it from investment. According to Ben Graham in Intelligent Investor The Intelligent Investor by Benjamin Graham, first published in 1949, is a widely acclaimed book on value investing, an investment approach Graham began teaching at Columbia Business School in 1928 and subsequently refined with David Dodd. Famous investor and billionaire Warren Buffett describes it as "by far the best book on investing ever, the prototypical defensive investor is "...one interested chiefly in safety plus freedom from bother." He admits, however, that "...some speculation is necessary and unavoidable, for in many common-stock situations, there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone."^[3] Many long-term investors, even those who buy and hold for decades, may be classified as speculators, excepting only the rare few who are primarily motivated by income or safety of principal and not eventually selling at a profit.

Speculating is the assumption of risk in anticipation of gain but recognizing a higher than average possibility of loss. The term speculation implies that a business or investment risk can be analyzed and measured, and its distinction from the term Investment is one of degree of risk. It differs from gambling, which is based on random outcomes.^[4] There is nothing in the act of speculating or investing that suggests holding times, have anything to do with the difference in the degree of risk separating speculation from investing.^{[citation needed]}

The economic benefits of speculation

Sustainable consumption level

The well known speculator Victor Niederhoffer Victor Niederhoffer , is a hedge fund manager, champion squash player, best selling author and statistician, in "The Speculator as Hero"^[5] describes the benefits of speculation:

Let's consider some of the principles that explain the causes of shortages and surpluses and the role of speculators. When a harvest is too small to satisfy consumption at its normal rate, speculators come in, hoping to profit from the scarcity by buying. Their purchases raise the price, thereby checking consumption so that the smaller supply will last longer. Producers encouraged by the high price further lessen the shortage by growing or importing to reduce the shortage. On the other side, when the price is higher than the speculators think the facts warrant, they sell. This reduces prices, encouraging consumption and exports and helping to reduce the surplus.

Another service provided by speculators to a market is that by risking their own capital In economics, capital, capital goods, or real capital are factors of production used to create goods or services that are not themselves significantly consumed in the production process. Capital goods may be acquired with money or financial capital in the hope of profit, they add liquidity In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value. Money, or cash on hand, is the most liquid asset. An act of exchange of a less liquid asset with a more liquid asset is called liquidation. Liquidity also refers both to a to the market and make it easier for others to offset risk Risk concerns the deviation of one or more results of one or more future events from their expected value. Technically, the value of those results may be positive or negative. However, general usage tends to focus only on potential harm that may arise from a future event, which may accrue either from incurring a cost or by failing to attain some, including those who may be classified as hedgers In finance, a hedge is a position established in one market in an attempt to offset exposure to price fluctuations in some opposite position in another market with the goal of minimizing one's exposure to unwanted risk. There are many specific financial vehicles to accomplish this, including insurance policies, forward contracts, swaps, options, and arbitrageurs.

Market efficiency and liquidity

If a certain market—for example, pork bellies—had no speculators, then only producers (hog farmers) and consumers (butchers, etc.) would participate in that market. With fewer players in the market, there would be a larger spread The bid/offer spread for securities (such as stock, futures contracts, options, or currency pairs) is the difference between the price quoted by a market maker for an immediate sale (bid) and an immediate purchase (ask). The size of the bid-offer spread in a given commodity is a measure of the liquidity of the market and the size of the 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 would be forced to accept an illiquid market In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value. Money, or cash on hand, is the most liquid asset. An act of exchange of a less liquid asset with a more liquid asset is called liquidation. Liquidity also refers both to a 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 In finance, the efficient-market hypothesis asserts that financial markets are "informationally efficient", or that prices on traded assets (e.g., stocks, bonds, or property) already reflect all available information, and instantly change to reflect new information. Therefore, according to theory, it is impossible to consistently.

Bearing risks

Speculators also sometimes perform a very important risk bearing role that is beneficial to society. For example, a farmer might be considering planting corn on some unused farmland. Alas, he might not want to do so because he is concerned that the price might fall too far by harvest time. By selling his crop in advance at a fixed price to a speculator, the farmer can hedge the price risk and is now willing to plant the corn. Thus, speculators can actually increase production through their willingness to take on risk.

Finding environmental and other risks

Hedge funds that do fundamental analysis "are far more likely than other investors to try to identify a firm’s off-balance-sheet exposures", including "environmental or social liabilities present in a market or company but not explicitly accounted for in traditional numeric valuation or mainstream investor analysis", and hence make the prices better reflect the true quality of operation of the firms.^[6]

Shorting

Shorting In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to the lender. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as may act as a “canary in a coal mine” to stop unsustainable practices earlier and thus reduce damages and forming market bubbles.^[6]

Some side effects

Auctions are a method of squeezing out speculators from a transaction, but they may have their own perverse effects In history and the social sciences, unintended consequences are outcomes that are not the results originally intended by a particular action. The unintended results may be foreseen or unforeseen, but they should be the logical or likely results of the action. For example, some historians have speculated that if the Treaty of Versailles had not; see winner's curse The winner's curse is a phenomenon akin to a Pyrrhic victory that occurs in common value auctions with incomplete information. In short, the winner's curse says that in such an auction, the winner will tend to overpay. The winner may overpay or be 'cursed' in one of two ways: 1) the winning bid exceeds the value of the auctioned asset such that. 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.^{[citation needed]}

Speculation can also cause prices to deviate from their intrinsic value if speculators trade on misinformation, or if they are just plain wrong. This creates a positive feedback Positive feedback, sometimes referred to as "cumulative causation", refers to situations where some effect causes more of itself. Under strong positive feedback, most systems quickly move to a limit state, where the limit is provided by external factors, or into some other new stable state where the positive feedback is somehow negated loop in which prices rise dramatically above the underlying value or worth of the items. This is known as an economic bubble An economic bubble is “trade in high volumes at prices that are considerably at variance with intrinsic values”. (Another way to describe it is: trade in products or assets with inflated values.). 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 A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors. They often follow speculative stock market bubbles.

In 1936 John Maynard Keynes John Maynard Keynes, 1st Baron Keynes, CB was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments. He identified the causes of business cycles, and advocated the use of fiscal and monetary measures to mitigate the adverse effects of economic wrote: "Speculators may do no harm as bubbles An economic bubble is “trade in high volumes at prices that are considerably at variance with intrinsic values”. (Another way to describe it is: trade in products or assets with inflated values.) on a steady stream of enterprise Entrepreneurship is the act of being an entrepreneur, which is a French word meaning "one who undertakes innovations, finance and business acumen in an effort to transform innovations into economic goods". This may result in new organizations or may be part of revitalizing mature organizations in response to a perceived opportunity. The. But the situation is serious when enterprise Entrepreneurship is the act of being an entrepreneur, which is a French word meaning "one who undertakes innovations, finance and business acumen in an effort to transform innovations into economic goods". This may result in new organizations or may be part of revitalizing mature organizations in response to a perceived opportunity. The becomes the bubble An economic bubble is “trade in high volumes at prices that are considerably at variance with intrinsic values”. (Another way to describe it is: trade in products or assets with inflated values.) on a whirlpool of speculation. (1936:159)"^[7] Mr Keynes himself enjoyed speculation to the fullest, running an early precursor of a hedge fund A hedge fund is an investment fund open to a limited range of investors that undertakes a wider range of investment and trading activities than traditional long-only investment funds, and that, in general, pays a performance fee to its investment manager. Every hedge fund has its own investment strategy that determines the type of investments and. As the Bursar of the Cambridge University King's College, he managed two investment funds, one of which, called Chest Fund, invested not only in the then 'emerging' market US stocks, but also periodically included commodity futures and foreign currencies, albeit to a smaller extent (see Chua and Woodward, 1983) . His fund achieved positive returns in almost every year, averaging 13% p.a., even during the Great Depression, thanks to very modern investment strategies, which included inter-market diversification (i.e., invested not only in stocks but also commodities and currencies) as well as shorting In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to the lender. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as, i.e., selling borrowed stocks or futures to make money on falling prices, which Keynes advocated among the principles of successful investment in his 1933 report ("a balanced investment position [...] and if possible, opposed risks.") ^[8]

According to Ziemba and Ziemba (2007), Keynes risk-taking reached 'cowboy' proportions, i.e. 80% of the maximum rationally justifiable levels (of the so called Kelly criterion In probability theory, the Kelly criterion, or Kelly strategy or Kelly formula, or Kelly bet, is a formula used to determine the optimal size of a series of bets. In most gambling scenarios, and some investing scenarios under some simplifying assumptions, the Kelly strategy will do better than any essentially different strategy in the long run. It), with overall return volatility In finance, volatility most frequently refers to the standard deviation of the continuously compounded returns of a financial instrument within a specific time horizon. It is used to quantify the risk of the financial instrument over the specified time period. Volatility is normally expressed in annualized terms, and it may either be an absolute approximately three times higher than the stock market index benchmark. Such levels of volatility, responsible for his spectacular investment performance, would be achievable today only through the most aggressive instruments (such as 3:1 leveraged exchange-traded funds An exchange-traded fund (also known as Exchange-Traded Product (ETP)) is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks or bonds and trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day. Most ETFs track an index, such as the S&). He chose modern speculation techniques practiced today by hedge funds A hedge fund is an investment fund open to a limited range of investors that undertakes a wider range of investment and trading activities than traditional long-only investment funds, and that, in general, pays a performance fee to its investment manager. Every hedge fund has its own investment strategy that determines the type of investments and, which are quite different from the simple buy-and-hold long-term investing.^[9]

It is a controversial point whether the presence of speculators increases or decreases the short-term volatility in a market. Their provision of capital and information may help stabilize prices closer to their true values. On the other hand, crowd behavior and positive feedback loops in market participants may also increase volatility at times.

Regulating speculation

The Tobin tax A Tobin tax, suggested by Nobel Laureate economist James Tobin, was originally defined as a tax on all spot conversions of one currency into another. The tax is intended to put a penalty on short-term financial round-trip excursions into another currency is a tax intended to reduce short-term currency speculation, ostensibly to stabilize foreign exchange.

In May 2008, German leaders planned to propose a worldwide ban on oil trading by speculators, blaming the 2008 oil price rises on manipulation by hedge funds A hedge fund is an investment fund open to a limited range of investors that undertakes a wider range of investment and trading activities than traditional long-only investment funds, and that, in general, pays a performance fee to its investment manager. Every hedge fund has its own investment strategy that determines the type of investments and.^[10]

On December 3, 2009, US Congressman Peter DeFazio Peter Anthony DeFazio is an American politician. He serves as a Democratic U.S. Representative from Oregon, representing the 4th Congressional District and is currently serving his 11th term. DeFazio is Oregon's most senior member of Congress, which makes him the dean of Oregon's House of Representatives delegation. A native of Massachusetts and a stated, "The American taxpayers bailed out Wall Street Wall Street is a street in Lower Manhattan, New York City, New York, USA. It runs east from Broadway to South Street on the East River, through the historical center of the Financial District. It is the first permanent home of the New York Stock Exchange; over time Wall Street became the name of the surrounding geographic neighborhood. Wall Street during a crisis brought on by reckless speculation in the financial markets.... This [ proposed financial transaction tax ] legislation will force Wall Street to do their part and put people displaced by that crisis back to work."^[11]

On January 21, 2010, President Barack Obama endorsed the Volcker Rule which deals with speculative investments of banks that don't benefit their customers. The Volcker Rule states that these investments played a key role in the financial crisis of 2007–2010.^[12]

Books

• Sobel, Robert (2000) [1973]. The Money Manias: The Eras of Great Speculation in America, 1770-1970. Beard Books. ISBN 1-58798-028-2.
• Gunther, Max (1992). The Zurich Axioms. Souvenir Press. ISBN 0-285-63095-4.
• Niederhoffer, Victor (2005). Practical Speculation. Wiley. ISBN 0-471-67774-4.

See also

• Adventurer
• Behavioral finance
• Black Wednesday
• Carbon credits
• Criminal charge
• Currency crisis
• Currency transaction tax
• DeFazio financial transaction tax
• Equity investment
• European crime
• Fictitious capital
• Financial markets
• Financial regulatory reform
• Day trading
• George Soros
• Jesse Lauriston Livermore
• Seasonal traders
• Short selling
• Slippage
• Spahn tax
• Speculative Attack
• Stock market bubble
• Stock trader
• Tobin tax
• Tulip mania
• Volcker Rule

References

1. ^ ^{a b} Graham, Benjamin, and David Dodd (1951). Security Analysis. McGraw-Hill Book Company. ISBN 0071448209.
2. ^ Mona Mahall and Asli Serbest (2009). How Architecture Learned to Speculate. ISBN 9783000298769.
3. ^ Graham, Benjamin (1973). Intelligent Investor. HarperCollins Books. ISBN 0060555661.
4. ^ Barron's ISBN 0-8120-4631-3
5. ^ Victor Niederhoffer, The Wall Street Journal, February 10, 1989 Daily Speculations
6. ^ ^{a b} Unlikely heroes - Can hedge funds save the world? One pundit thinks so, The Economist, 2010-2-16
7. ^ Dr. Stephen Spratt of Intelligence Capital (September 2006). "A Sterling Solution". Stamp Out Poverty report. Stamp Out Poverty Campaign. p. 15. http://www.stampoutpoverty.org/?lid=9889. Retrieved 2010-01-02.
8. ^ Chua, J. H. and R. S. Woodward (1983). "The Investment Wizardry of J.M. Keynes". Financial Analysts Journal 39 (3). pp. 35–37. http://www.jstor.org/pss/4478643. Retrieved 2010-01-26.
9. ^ Ziemba, Rachel and William Ziemba (2007). "Good and Bad properties of the Kelly criterion". John Wiley & Sons. pp. 29–31. http://www.wilmott.com/pdfs/050316_ziemba.pdf. Retrieved 2010-01-26.
10. ^ Evans-Pritchard, Ambrose (May 26, 2008). "Germany in call for ban on oil speculation". The Daily Telegraph (The Daily Telegraph). http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/05/26/cnoil126.xml. Retrieved 2008-05-28.
11. ^ Charles Pope (December 3, 2009). "DeFazio calls for tax on financial transactions but critics abound". The Oregonian, OregonLive.com. http://www.oregonlive.com/politics/index.ssf/2009/12/defazio_calls_for_tax_on_high.html. Retrieved 2010-01-04.
12. ^ David Cho, and Binyamin Appelbaum (January 22). "Obama's 'Volcker Rule' shifts power away from Geithner". The Washington Post. http://www.washingtonpost.com/wp-dyn/content/article/2010/01/21/AR2010012104935.html. Retrieved 13 February 2010.

External links

• Congress Plans to Tighten Rules on Energy Speculation

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