Understanding Speculation
Definition of Speculation
Speculation is the act of engaging in risky financial transactions in an attempt to profit solely from price fluctuation.
Those that speculate, referred to as speculators, pay little attention to the intrinsic or fundamental value of the asset they are acquiring, and thus do not attempt to examine how the underlying financial or economic attributes may influence price movement. For example, a speculator would not consider how a business may add value to their products and services in order to generate larger returns, or how income producing assets may generate profit through dividends/regular payments as opposed to price appreciation.
Investing versus Speculation
Often speculation is mistaken for investing, especially in fields like real estate and rare collectibles. Investing is defined as the act of committing resources to an endeavour or entity which, upon thorough analysis, promises satisfactory return and safety of principal. For a more detailed explanation, see the understanding investing article.
What is important to distinguish here is that those who speculate, do not conduct a thorough analysis of the asset under consideration, and, in turn, do not ensure that there is a low risk of the permanent loss of principal. Therefore, their operations cannot be classified as investing.
The differences between investing and speculating are summarised in the following table:
| Investing | Speculating | |
|---|---|---|
| Resource committed | Yes | Yes |
| Thorough analysis | Yes | No |
| Satisfactory return | Yes | Yes |
| Safety of principal | Yes | No |
Two real world examples of speculation will be detailed.
Example 1: Real Estate Speculation
An individual hears that property prices in their city are going up, and that real estate is an infallible investment as it never drops in value. With this information in mind, they go to an area that has seen the most growth over the last few years and purchase a property using the maximum amount of leverage they have available, with the intent to resell it in a few years for a profit.
There are various markers in this situation which indicate that the individual is speculating and not investing, some of which include:
- Idea spurred by group think.
- Failure to conduct thorough research.
- No investment thesis to support price appreciation or margin of safety.
- Reckless use of substantial leverage exacerbating risk.
- Short-term holding period with the
hope
of profit.
As a side note, in finance, leverage refers to the use of borrowed money to amplify investment returns and is usually expressed as a ratio. For example, a 1:2 leverage ratio would allow an investor to borrow $2 for every $1 they put down as a deposit. This borrowed money would then be used to amplify returns (and also potential losses) by two-fold. Typically, real estate loans will provide between five (1:5) and ten times (1:10) leverage. However, in some circumstances, like market booms, it may get as high as twenty times (1:20).
Example 2: Stock Picking Speculation
An individual sees the stock market making new highs and decides to invest in some well-known companies that have surged in price over the preceding months. The companies are trading at elevated prices, have a significant amount of debt, and their interest payments are not well-covered by earnings. However, none of this information is considered during the investment process. Instead, the individual believes that the companies are safe because they are large, and that they will continue appreciate in value because they have done so recently. The operation does not satisfy the criteria for investing and is therefore classified as speculation.
Summary
To summarise, speculation is the act of engaging in risky financial transactions in an attempt to profit solely from price fluctuation. Those who speculate, do not conduct a thorough analysis of the asset under consideration, and in turn do not ensure that there is a low risk of permanent loss of principal. Because of this, the operation does not meet the definition of investing and is therefore considered to be speculation.