Speculation is easy, it requires no hard work. It is exciting; you can buy and sell at every refresh of your screen. It is not unusual for speculators to sit with four computer screens in front of them, each showing the live price quotes of different segments or different markets. (Rakesh Jhunjhunwala, one of the most successful investors handles five screens simultaneously. Actually, Jhunjhunwala has Jekyll and Hyde personalities. One personality is a speculator; another is a long term investor. But that is beside the point) Speculation is as thrilling as casino, and if the market is trending, lucrative too. But it is a lottery, some day you win some day you lose. Speculators firmly believe there is a greater fool sitting at another terminal, you buy at Rs 100, and he will buy at Rs 110 from you. When yo don’t find the greater fool, well the market has found the greatest fool: YOU.
Is speculation bad for the market?
I am often asked this question by people who do not understand intricacies of market. Whenever people lose money, these sentiments are echoed. On October 11, Sensex fell by more than 1000 points, and the Economics Times reported that investors lost a wealth of Rs 4 lakh crore in 5 minutes. The blood on the street usually belongs to the speculators, and not investors. And when they spill blood, often you hear that speculation should be ‘banned’. Such sentiments are often expressed in the commodities market too. When the oil prices rises suddenly all fingers point at speculators, and people start blaming government for creating infrastructure for speculators to indulge in excessive speculation. It looks so obvious, if something is so bad, should it not be declared illegal? Well, the simple answer is, speculation is not at all bad for the market. Speculation may make the speculator an overnight king or pauper, since he wins big and he loses big; yet it does perform important economic functions for the market. Presence of speculators helps, not hinders the attainment of perfection in the market. Let us try to understand what at first sight looks like a paradox.
As discussed earlier, speculation is the practice of engaging in risky financial transactions in an attempt to profit from short term fluctuations in the market value of a security—rather than attempting to profit from the underlying financial attributes embodied in the instrument such as capital gains, dividends, or interest. Speculators pay little attention to the fundamental value of a security and instead focus purely on price movements. In doing so they perform a host of economic functions:
- Price stabilisation function: While this applies to commodities as well as securities, it will be easier to understand it as it applies to commodities. The economist Nicholas Kaldor has long recognised the price-stabilising role of speculators, who tend to even out “price-fluctuations due to changes in the conditions of demand or supply.” The speculator and hedge fund manager Victor Niederhoffer has beautifully explained this thus:
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.
The speculator is an opportunist. He makes hay while the sun shines. He looks for imperfections and gaps. He makes money by filling the gap. Speculators, along with arbitrageurs and hedgers keep exploiting the price gap. This in turn leads to a more perfect market with a more logical pricing. Contrary to what we believe, speculation is good for price stabilisation in the long run. In the short run, speculation may cause hiccups in the market, but that is a part of long term stabilisation process.
- Providing liquidity to the market: Another important service that a speculator provides to the market is-risking his own capital-he creates liquidity. Let us understand why this is so important. We shall again use the example of a commodity, since it is easier to understand. We consider a thinly traded commodity on NCDEX(which is the commodities market in India), say guar gum. Guar gum is an extract derived from guar seeds, and is used as natural thickener, emulsifier, stabiliser, bonding agent etc. When a chemical manufacturer wants to buy guar gum, he goes to the market, and he finds no seller, since the trades are not frequent. Conversely, when a seller of guar gum wants to sell, there may not be enough buyers. In the former case, the buyer will have to pay a premium over the normal price, since there is not as much quantity up for sale as is the demand. In the latter case the seller is likely to get a lower price. This price difference- technically known as “the spread”- occurs because there are not enough numbers of buyers and sellers at the same point in time. The speculator- an opportunist-will buy or sell any commodity where he finds the spread is large. He is essentially risking his capital, and filling the gap. Since speculator often works with leveraged money, he has the capability to buy as much as 10 times the actual buyer, and can sell as much, without owning a piece (thanks to the futures market). A market filled with a mix of investors (or actual users in commodities market) hedgers, arbitrageurs, and speculators, you can imagine how much will the volume increase. It may be as high as 100 times the actual trade. (In stock market as well as in the commodities market you can find out how many of the deals are being settled for ‘delivery’ and how many are being ‘rolled over’) The presence of a large number o players leads to greater market efficiency, greater quantity being traded lowers the ‘spread’ this helping both buyers and sellers in the process. It may sound ridiculous but in tiny commodities like guar gum the daily traded volume may sometimes be more than the annual production of the commodity!
- Bearing risk: Speculator loves risk; he earns his bread by taking risk. Sometimes he gets cake to eat, sometimes he sleeps empty stomach. He takes upon himself the risk that the seller or buyer of the commodity (or the investor in securities) would have been required to assume. The farmer can enter into a contract to sell his produce to a speculator in a forward market, and can sleep peacefully, knowing that his produce is pre-sold.
So much in praise of the hero of the market. And I am sure now you understand why you need speculators to help you succeed as investor. Consider a hypothetical situation, where every investor in the market is a clone of Warren Buffett. Everyone buys the mismatch between price and value, if everyone does that, there will be no gap left soon, and once you stage of equilibrium between value and price, there is no further profits to be made, except the profit arising out of the growth of the company. Equity market will have to be closed down, since the uncertainty is gone. When all become Wrren Buffett, Warren Buffett will be reduced to purchaser of what looks like an equivalent of government bond. Of course, this would never happen, thank you Mr. Speculator.
©Dr. Tejinder Singh Rawal
M. Com, MA (Economics), MA (Public Administration), MA (Urdu), LLB, FCA, ISA, CISA, CISM, PhD
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This discussion will be a part of the forthcoming book by me “The Smart Long Term Investor: Common Sense Strategies for Wealth Creation” Suggestions are welcome and will be appreciated