What is speculation and how does it affect your investments?
Speculation is a risky investment strategy where the goal is more focused on making a quick profit by taking advantage of price fluctuations in the markets. While the strategy sometimes works out well, 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.
While speculators have been around for a long time, there has been increased speculation in the markets since the start of the COVID-19 crisis. That’s because the pandemic sent stocks quickly tumbling at the beginning of 2020 when the crisis first struck, before surging to new highs in the months that followed, largely in response to low interest rates and the extraordinary amount of monetary stimulus flooding the markets from the Federal Reserve.
Why speculation is a risky investment strategy
In short, speculation is quite risky. 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 and it does, it can 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
The biggest reason to avoid speculation in stock trading is the fact that it 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 can 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 to the extent that one can. That means looking for companies that have the best long-term prospects, not just the ones in the news on any particular day.
How speculation affects commodities
Speculators do 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 themselves.
- Speculators provide liquidity to the market by buying and selling commodities, such as oil and wheat.
- Speculators help to 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 eat into consumers’ purchasing power. 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 with respect to other currencies 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 it.
Conversely, if a central bank wants to reduce the supply of money moving through the economy, it can:
- Raise interest rates. In 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. Although currency speculation can indeed be profitable, 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.
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 order to avoid the pitfalls, and strongly consider sticking to a long-term investment plan instead.
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.