Behavioral finance FAQ / Glossary (Speculation)

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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

(financial) Speculation

06/1d + anticipation, active
management, gambling.

Betting on the future.

Is it submission to 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, a move

    based on a mental attempt to anticipate the future, whatever

    its uncertainties.

In this broad practical meaning,

Speculative decision-making (*) is a typical human art
and everyday activity done consciously practically

by everybody.


An exalted statement ? On the contrary, a basic reality as the simple fact
that anticipating the future is one of the main differences between 
human beings and lettuces (and with any other bipeds, quadrupeds
or centipedes, as animals are driven mostly by instinct).

(*) Speculative thinking is common also, but its meaning is
      different, as something akin to metaphysics and meditation,
      not to action.

2) More specifically, financial market speculation, our topic
here,

is committing (and risking) money on

predicted

      asset price variations.

In financial market speculation is often attributed to short term
trading
,but the notion can be extended to various risky long term
investments.

On the other hand, short term "martingales" in the form of
arbitrages done to take advantage of occasional price differences

on the same asset or similar assets cannot be normally seen 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
aresupposed to accept (in fact they are tools to transfer
risks
).

Those markets allow to "bet":

On price rises as well as  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, and it is quite
    useful for society, when you invest in a
new business in a completely
    new field
.

It will usually take time, and encounter pitfalls, 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

Demonization.

Speculation, and even more financial speculation, have a bad image.

Many people will deny that they speculate, although it is an everyday
normal, even noble, human activity
as seen in the definition above  .

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 subconscious fears.

There is the idea that to anticipate things is a sinister activity inherited
from witchcraft.

Another thing is tnat when speculation is going wild and widespread it creates
excesses
such as overleverage, bubbles (see those words, and also the
sections below) that are damaging for the economic sphere.

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
poistive economic future.

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 risks
.

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 supervised markets.

...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 BF 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
BF polls

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