Behavioral finance FAQ / Glossary (Speculation)
This is a separate page of the S section of the Glossary.
Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed, i: incidental
06/1d + anticipation, active management,
Betting on the future. Is it witchcraft?
Or our first duty and human superiority over the animal
and material world?
Or an illusion, as uncertainty is king and speculation is
a Promethean trip in its kingdom?
General and specific definitions
Living in the future. Or at least preparing for it.
1) In the general sense, speculation is taking a risk and
expecting a reward, on the basis on an attempt to
anticipate the future, whatever its uncertainties.
In this broad practical meaning, speculative decision-making (*) is
an everyday activity done consciously practically by everybody.
Anticipating the future is one of the main differences between human beings
and lettuces (and with any other bipedes, quadrupedes or centipedes, as animals
are driven mostly by instinct).
(*) Speculative thinking is common also, but its meaning is different,
as something akin to meditation, not to action.
2) More specifically, financial market speculation, our topic here, is
committing (and risking) money on predictedasset price variations.
Speculation is often used to label short term trading in financial markets,
but the notion can be extended to various risky long term investments.
On the other hand, short term "martingales" in the form of arbitrages to take
advantage of occasional price differences on the same asset or similar assets
cannot be normally considered as speculative, although some exceptional event
can perturb the deal.
Is there a difference between financial speculation and investment?
Speed vs. distance.
Financial speculation is usually considered to differ from investment under two aspects,
The time horizons,
The types (and degrees) of risks / rewards.
Speculation is often used as a synonym for trading
(active buying and selling resulting in short term operations).
Here, small - but fast an frequent - gains, due to price variations, are
expected,by accepting high costs and risks.
As seen above, short time trading goes often further than mere arbitrages
to take advantage of small price discrepancies.
Future markets, and financial derivative markets, created
as hedging tools, are also used as privileged tools of speculation.
When used that way they entail high risk, which speculators are
supposed to accept (in fact they are tools to transfer risks).
Those markets allow to "bet":
On price rises as well as on price falls,
In a "leveraged" way, with only a small
wager compared to the asset amount at play.
Investment is supposed to describe more stable / less risky
operations. Their purpose is to get long term rewards such as:
Either long term regular income (dividends, even when they are not
spent but "capitalized", meaning reinvested),
Or - here it is more "speculative" - large enough long term capital gains
on riskier assets.
The border between the two practices is quite blurred in reality, at least if we focus
on the time criterion:
You can make long term speculation when you invest in a new business
in a completely new field.
It will usually take time, and encounter obstacles, to find its market.
But the hope is that this market could be huge and highly profitable.
Such "visionary" speculation involves therefore higher return prospects, at the cost of
higher risks, than more traditional investments.
At the same time, you might expect that soon after you other investor will discover
those bright prospects and will offer a higher price and bring you a fast profit.
Thus, some short term speculation might be involved (remember the dotcom bubble).
Another common confusion: speculation and gambling
Dice and the market (see below)
The biased mental images attributed to speculation
Speculation, and even more financial speculation, have a bad image.
Many people will deny that they speculate, as an everyday normal human activity
as seen in the definition.
The word is not exactly politically correct and the activity is often demonized,
usually in bad times when economic instability strikes (high or depressed prices, shortages,
recessions..), even when speculation is just the thermometer of other imbalances.
Even if it has its own failures, like any human or social activity (see below), the bad image
of speculation might also arise because it is often confused with:
Gambling (see that word), a behavior that can become biased, addictive
and sometimes disastrous.
Of course some speculations have common traits with gambling, if only because it is
a risky activity.
But there are at least as much difference than similarity (see "gamble").
See - in the "Gamble" article -
the "Gambling / investment / speculation" comparison table.
Or manipulation (a quite different thing than speculation, see that word).
Or even "human exploitation" - nothing less, as if trying to anticipate
events is enslaving the toiling mankind by blood-thirsty / money-thirsty nabobs.
Not to talk about an impression of black magic which might be present in collective
There is the idea that to anticipate things is a sinister activity inherited from witchcraft.
The real pros and cons of financial speculation
Does short term trading make markets smooth? Or rough?
On the plus side, normally, speculation does several useful things:
It is supposed to anticipate economic events, and thus to favor
a good allocation of capital.
It would orientate resources towards activities with an expected positive
It could give an advance signal of some economic imbalances (shortage,
glut, inflation...) or other flaws (loopholes) and dangers.
It adds liquidity to the market, bringing counterparts to sellers and buyers.
It could also correct pricing anomalies through arbitrage.
Well, as seen below, speculation can also bring its own price anomalies.
When it deals with derivatives, it provides an hedging tool for economic
On the minus side, speculation can sometimes become exuberant.
In such cases, short term speculators might lose sights
of the fundamentals and of the real prospects of the assets they trade,
until reality comes back with a revenge.
Here are some specific harmful incidences:
This might burn capital on illusory prospects,
It can bring excessive market price moves such as crashes or bubbles.
This can even create illiquidity (contrarily to the purpose seen above) when
speculators behave all in the same direction, creating a lack of counterparts.
Also speculation might be boosted by manipulators, at the expense of
other investors (see manipulation).
This should in theory be limited to rare cases in seriously organized and
...which is not always the case as market
authorities can be contaminated by:
* The exuberant atmosphere and general gullibility,
* The belief that market are always "efficient",
* Not to forget some possible collusion.
Stock market speculation, in the form of short term trading, might
go against the long term strategy and interests of the business:
Traders can be less interested in the long term interest of a firm than stable
shareholders who normally would feel more responsible.
This can entice the company, so as to please the stock market, to privilege
short term results.
When speculation is done by bank traders, it can create a specific risk for
customer deposits and savings.
A related issue is whether bank traders' bonuses are perverse
incentives. See the "perverse incentive" article of that glossary.
(*) To find those messages: reach that Behavioral-Finance group and, once there,
1) click "messages", 2) enter your query in "search archives".
Members of the Behavioral Finance Group, please vote
on the glossary quality at Behavioral-Finance/polls