Saturday, September 13, 2008

The Need for Speculators

The US Congress will soon be dealing with a report that allegedly points the finger at “speculators” being a principal cause in the run up in the price of oil. For Congress that means gasoline at the corner service station. In a knee-jerk reaction there will be a call to ban or curtail the activities of these devils even though the report does not conclude that speculators were the cause for the run up in gasoline prices.

Before condemning such a move by the Congress, I believe one should understand the essential difference between an investor and a speculator. An investor (perhaps this person should be called a historian) is comfortable projecting the future from an examination of the past. One might call such a person is a trend follower. As human behavior and weather cycles have not changed much for hundreds of years, the odds of a continuation of past trends are a good, but not perfect, guide to the future.

A speculator is someone that believes that the current time is different in some important respect such as product, people, or prices. The ultimate question for any market participant is who is going to buy (sell) this security when the current price has too much risk built-in?

Most investors are governed by their internal price disciplines. Often when one investor is worried that a price is overly generous or overly depressed they need to find a market participant who sees things differently. Thus after considerable upward momentum the investor needs to find a speculator who believes “this time” it is going to be different, and thus is a buyer of the investor’s securities.

In the same fashion, after a sustained decline an investor searches for a speculator who believes that the “normal” cyclical bounce will not follow, and that prices will continue to decline. In my examples the investor wins over the speculator, which is not always the case in practice. The speculator must win enough to be enticed into the game or they won’t play. That is why waves of speculation are dispersed in history to allow for new participants to follow their speculative urges.

Our sympathy is for our readers and clients who are long-term investors. We all need speculators to provide generous exits and cheap entry points. From a national policy perspective, speculation provides the grease that encourages markets to be efficient and aids in price discovery by often providing the other side of the trade.

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