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What is speculation?

At its core, speculation is the act of trading in high-risk assets with the expectation of substantial returns. Speculators, unlike typical investors, focus on leveraging market fluctuations for maximum gains rather than sticking to long-term investment strategies. They might use tactics like adjusting their position size, using stop-loss orders and tracking their trading performance metrics on a daily basis.

Speculation is a risky investment strategy. While it sometimes works out, speculation is more likely to lead to losses, especially when volatility is high.

Speculators often trade assets, like stocks or cryptocurrencies, in an effort to time the market. They hope to buy when prices are near their bottom, and sell when the price is near its peak. But in reality, it’s much harder than it sounds.

Speculators have been around for a long time. A recent example of widespread speculation began at the start of the COVID-19 crisis. The pandemic sent stocks quickly tumbling at the beginning of 2020 before surging to new highs in the months that followed, largely in response to low interest rates and the  amount of monetary stimulus flooding the markets from the Federal Reserve.

Speculators play a crucial role in financial markets as they absorb extra risk and provide much-needed liquidity by buying and selling when other investors are holding. Speculation can involve any tradeable good or asset – a key difference from investing, where decisions are generally based on research and fundamental analysis, such as business performance metrics.

Why speculation is a risky investment strategy

Speculators seek quick profits, usually by predicting the direction of prices. In theory, it can work out well. If you predict the price of an asset will rise over a short period of time and it does, then it may be much more profitable than if you bought the asset and held it for the long haul.

However, a long-term investor is much better positioned to ride things out during times of extreme volatility, compared to speculators who tend to face immense pressure on their portfolios in this type of market environment.

Speculation is a strategy that offers the potential for a significant payoff, but also comes with a substantial risk of loss.

How speculation affects stocks

Speculation in stock trading often hurts a stock, rather than helps it. Speculation often leads to panic in volatile markets. Losing investors start to sell off their positions, which causes their stocks to go down even further, which leads to even more selling and so on.

Investors should also beware of fast money, which refers to investors who are in and out of stocks fast, hoping for returns that are too good to be true.

Instead of speculating, investors should  look for other ways to boost returns by investing in companies that have the potential for long-term growth. That may mean investing in companies that have strong competitive advantages and a dominant position in the market, or it may mean investing in sectors that are experiencing rapid growth. Investors should also look for companies that have good management.

It’s important to focus on investing in quality stocks. That means looking for companies that have the best long-term prospects, not just the ones dominating news headlines  on any particular day.

How speculation affects commodities

Speculators play an important role in the commodities market and the economy in general. Without speculators, there would be far less liquidity in the market, and it would be much harder for producers and consumers to find ways to hedge their investments by matching up their current requirements with future expectations.

Some of the benefits of speculative trading in commodities include:

  • Speculators take on the risk that producers or consumers are unwilling or unable to take on.
  • Speculators provide liquidity to the market by buying and selling commodities, such as oil and wheat.
  • Speculators help keep prices at levels that are representative of the best possible prices.
  • Speculators may assist in providing market stability.

If you’re a consumer, however, you probably don’t like speculators as much. Speculators often drive commodity prices higher and that can lead to higher prices for consumers. That’s why you’ll often hear politicians railing against speculators for pushing up the prices of gas or food.

How speculation affects currencies

Speculation in currencies can also be quite risky, as it involves the expectation of profiting from the changing of a currency’s value with respect to another currency.

A nation’s central bank can greatly affect the value of its currency through its monetary policy.

If the central bank wants to expand the supply of money moving through the economy, it can:

  • Sell its currency and buy another one to make it have less value.
  • Lower the interest rate it pays on deposits, discouraging people from depositing their money in the country’s banks and instead encouraging them to spend or invest it.

Conversely, if a central bank wants to reduce the supply of money moving through the economy, it can:

  • Raise interest rates. By doing so, the value of its currency would appreciate, encouraging people to deposit their money in financial institutions.
  • Buy its own currency by using its reserves of foreign currency.

Monetary policy isn’t the only source of currency fluctuations. Trading by speculators can also have a dramatic impact on short-term foreign exchange prices. Currency  speculation can  be profitable, but it comes with a very high risk of loss. Speculators try to figure out when one currency is undervalued and another is overvalued. But their trading activity can make currencies even more volatile.

Bottom line

While some forms of speculation can have positive outcomes, there are many instances where speculation can be extremely detrimental to your financial health. Investors should be aware of the elevated levels of risk involved in speculation. While quick gains may be temping, long-term investing is a safer and more reliable way to build lasting wealth.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.