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LeoGlossary: Speculation

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In the financial world, speculation is the purchase of an asset based upon anticipated pricemovements. Those engaging in this are rarely concerned with fundamentals. The goal is to capture large moves in the market for gain.

Speculation is tied directly to risk and how much one is willing to take on.

Investing Versus Trading

Some believe that people making investments are not speculating. To them, that is only for traders.

One of the primary differences between investors and traders is time. Their view on assets can be similar. Both are looking for the price to move up (or down if shorting). This is a major part of their return.

Speculation in investments are very common. When the movement of price is necessary to provide a return (either all or in part), that is speculation.

An example is a stock that does not pay a dividend. Buyers are seeking to have the price move up.

Speculation Versus Yield

Investors who seek yield are often not engaging in speculation. The returns come in the form of payouts such as investing in debt. Interest is commonly sought as a form of yield by investing in a savings account or certificate of deposit.

There is no dependence upon price movement to affect the return. Even bonds, which can see price appreciation or depreciation, are considered fixed income instruments. While market prices are variable, the amount of money paid out over the life of the asset is fixed. One simply needs to hold the asset until maturity to realize the return.

What approach is right depends upon a number of components. Factors such as age, risk-tolerance, and income status are just some of the things individuals have to consider.

Assets

Assets that people typically speculate upon:

This is considered taking on risk as markets can often move in the opposite direction as expected. Thus, if someone is long an asset, a decline in price will result in a loss. A similar result is realized if one is short the asset yet it moves up in price.

People often look to maximize their return by leveraging up their speculative investment/trade. This is often done through the use of derivatives, which can also be used to hedge a position.

Risk Scale

The general idea that market participants weight the potential of loss in value of an asset in contrast to the expectation of gain.

There are many models employed to do this. Hedge funds are investment options designed to minimize downside risk by maintaining a neutral position.

In the digital era, algorithms are employed by the largest financial institutions in an effort to balance the risk/reward ratio.

Bubbles occur in markets when speculation gets out of control. This was the case in Tulip Mania, the Dot Com Bubble, and The Roaring 20s, in the U.S.

Additional risk can be assumed when liquidity becomes an issue. If this dries up, an asset could become difficult to sell since prices can drop.

An example of this was the banking crisis in 2023 in the United States. The Federal Reserve raised interest rates, affecting bonds and other income assets. When this occurs, previously issued assets that have a lower rate will suffer a decline in value. This affected the banks ability to either unload the assets to raise the capital necessary to meet the withdrawals or use as collateral in stop-gap loans.

This led to to the collapse of 3 regional banks.

The problem is bank executives were buying securities with the intention of gaining a return as opposed to the backing of deposits based upon liquidity needs.

Business Speculation

Most business decisions are based on speculation in some form. Nobody can foresee the future. Expanding product lines, opening up new offices, or entering different markets are all examples of decisions made by executives which require a degree of speculation.

The difference between this and gambling is the individuals try to garner as much information as they can. Informed decisions is the concern as opposed to simply blindly entering based upon "a tip".

There is a degree of risk a corporation takes on when making decisions of this nature. The same is true in not taking these actions since markets (and economies) are dynamic, never sitting still. Technology only made this worse as disruption is common.

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