Whether speculation has a place in the portfolios of investors is the subject of much debate. Proponents of efficient market hypothesis believe the market is always fairly priced, making speculation an unreliable and unwise road to profits. Speculators believe that the market overreacts to a host of variables. These variables present an opportunity for capital growth.
Some market pros view speculators as gamblers, but a healthy market is made up of not only hedgers and arbitrageurs, but also speculators. A hedger is a risk-adverse investor who purchases positions contrary to others already owned. If a hedger owned 500 shares of Marathon Oil but was afraid that the price of oil may soon drop significantly in value, he or she may short sell the stock, purchase a put option or use one of the many other hedging strategies.
An arbitrageur tries to capitalize on inefficiencies in the market. The newest example of this is latency arbitrage. A form of high-frequency trading, latency arbitrageurs attempt to take advantage of the time it takes quotes to travel from the stock exchanges to buyers, by placing their computers in the same data centers as stock exchange servers. Investors can profit by taking advantage of these microsecond delays.
What Is Speculation?
Each of these investors is essential to an efficient and healthy market, but what is speculation and why does it attract such passionate criticism?
Economist John Maynard Keynes is one of the giants of finance. He said that speculation is knowing the future of the market better than the market itself. Instead of purchasing stock in what the investor regards as a high-quality company with long-term upside potential, the speculator looks for opportunities where significant price movement is likely. Assume that investor A purchased 300 shares of Boeing because he or she believed that the aviation and aerospace industry is growing rapidly. If the price of Boeing dropped tomorrow for no fundamental reason, he or she would likely purchase more stock because the price drop represents a better value.
Investor B, the speculator, might sell 300 shares because he or she believed that Boeing was poised for a short- or medium-term price increase. Investor B may have evaluated the health and other fundamentals of Boeing but his or her primary metric was the anticipated short-term price movement.
Opponents of speculating believe that investing money solely based on an event that may happen in the near future is gambling. Speculators argue that they use a large amount of data sources to evaluate the market where most gamblers bet purely on chance or other less statistically significant indicators.
Is Speculating as Easy as It seems?
John Maynard Keynes went on to say, "… casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of stock exchanges." Keynes knew in the early 20th century what statistics appear to show today. Trying to beat the market is as difficult as trying to beat a casino.
One study conducted by the North American Securities Administrators Association found that only 30% of speculators participating in day trading were profitable and only 12% had the potential for longer-term profitability.
Profitable speculators often work for trading firms that provide training and resources designed to increase their odds of success. For those who speculate independently, a large amount of time is necessary to research the market, follow breaking news events and learn and understand complicated trading strategies.
How to Speculate
The art of speculating covers a wide range of trading tactics, including pairs trading, swing trading, employing hedging strategies and recognizing chart patterns. Speculators are often skilled at fundamental analysis, including spotting over- or under-valued companies, the amount of short interest a company holds, and analysis of earnings and other SEC statements.
Along with evaluating products, a skilled speculator knows that the short-term movements of the investment markets are largely tied to world events. A Middle East conflict could affect the price of oil, a key eurozone figure could cause a violent move in the broad market indexes, and a material change in the unemployment rate could send markets soaring or plunging.
The odds may be against speculators but those who make the strategy a profitable venture are highly-skilled market watchers, investment product evaluators and have the experience to read the mood of the market.
Is Speculation Appropriate for Your Portfolio?
Baby boomers close to retirement are trying a new investment strategy, according to the Los Angeles Times. Instead of the passive investment strategy that most employees use for their retirement accounts, an increasing number of people have turned to speculating in an attempt to catch up on shortfalls in their retirement accounts.
John C. Bogle, founder of The Vanguard Group, advises people to stay with long-term investing. He points out in his book, "The Clash of the Cultures: Investment Vs. Speculation," that beating the stock market is a zero-sum game. Attempting to beat the market with retirement funds, when the majority of traders fail, is an unwise use of money that you will later rely upon when you're unable to work.
Most financial planners believe that speculation is only appropriate in a brokerage account using funds that aren't essential for the daily support of yourself or your family. Before participating in speculating, pay off debt, fund your retirement account and start a college fund, if necessary.
Regardless of how you speculate, it should be a small part of your overall investment portfolio.
Learning to Be a Speculator
Every skill takes time to learn and master. Before trading with real money, set up a virtual account through one of the many discount brokers or free websites. Learn how the market behaves and watch how your favorite stocks react to market events.
Traders cite the book, "How to Make Money in Stocks" by William O'Neil, as a valuable reference for learning the art of speculation. This book, and many others, provides the aspiring trader practical tips on trading and risk management.
Finally, building a community of traders that you trust, and analyzing their trades, is a valuable resource. Consider building a Twitter or Facebook list of successful traders. Find traders in your area and join an investing or traders club. Learning by yourself will rarely produce successful results. Take advantage of other people's experiences and offer to share your knowledge too.
The Bottom Line
Speculation is rapidly growing in popularity because of the easy access to world investment markets through online brokerage portals. Because speculation is difficult to master, spend time trading in a virtual account. When you're seeing a sustained track record of success through both up and down markets, only then should you consider speculating with real money.
The Internet and financial media may encourage speculation, but that doesn't mean you should follow the herd. Successful speculating takes a lot of skill, time and experience to master, that most people who work outside of the financial industry don't have. A more passive approach is likely to yield better results once dividends and long-term capital growth are considered.
More From Investopedia