Sunday, April 24, 2005

Should You speculate?

Here is my working definition of the word "speculate": buying or selling an asset (e.g. stocks, bonds, foreign exchange, commodities, real estate) to profit from a change in its price over a relatively short span of time (e.g. a year or less).

So, should you speculate?

NO!!!!!!

DON'T DO IT!

YOU WILL BE SORRY IF YOU TRY!

Well, that's a pretty strange piece of advice coming from someone whose business is speculation! But let me try to persuade you it is the right answer to give 99% of the people who are inclined to speculate, whether or not they are smart enough to ask this question in the first place.

First, let's dispose of an obvious issue. I am a speculator. Like any businessman, I don't want competition, so it is in my interest to discourage potential competitors.

To paraphrase John F. Kennedy, let me say this about that. There is an ocean of people out there who speculate, whether or not they do so intentionally. Adding one more speculator is like adding spit to the ocean - it's not going to make a bit of difference. Moreover, to continue our aquatic metaphor, novice speculators are at the bottom of the food chain of the speculative ocean and only serve to fatten up those closer to the top (e.g. me).

Having disposed of the self interest issue, let's return to our original question. Should you speculate?

Well, you probably want to speculate because you think you can make money speculating, enough money to justify the time and effort you put into it. (I am not addressing those who speculate to satisfy their urge to gamble and take unnecessary risks). Fine. But how likely is it that you will really will increase your income and net worth?

It's very easy to become a speculator. All you need is a few hundred dollars and an internet hookup. And that is precisely the problem. Why?

THE BUSINESS OF SPECULATION

Speculation is what economists would call a constant sum game. There is a single "pie" out there that is the compensation to speculators as a group for providing liquidity to markets, improving the price discovery process and providing insurance to producers who want to hedge. The more people who compete for that pie the smaller is the average piece any one individual can reasonably expect to get. And it is so easy to become a speculator that this average piece is very small, so close to nothing at all that you won't be able to tell the difference.

But the situation is worse than that. First of all, trading costs in the form of commissions and bid-ask spreads have to be paid in order to speculate. In other words, brokers get their slice of the speculative pie before anyone else does.

Moreover, we all know that there are hugely successful speculators out there in the investment world. Their success might be due to merely to luck but this is irrelevant. What is relevant is that they "eat" almost all of the remaining pie, leaving only "negative" pieces for everyone else. So when you speculate it is almost certain that you will reduce your net worth in the process of "feeding" brokers and the successful big speculators.

WHAT'S YOUR EDGE?

"Wait a minute", you might interject, " I'm quite a bit smarter that the average person. Why won't this allow me to succeed as a speculator, at least if I am willing to pay the reasonable cost in time and money of a normal apprenticeship. After all, I have been very successful in my current profession of ...... (e.g. law, medicine, small business, big business, etc.).

Sad to say, intelligence has little to do with success in speculation. Indeed, my observation is that the biggest losers in the speculative game are people of above average intelligence. It is their intelligence that helps them make the money that they then proceed to lose to the "street smart" speculators at the top of the food chain. And it is their intelligence that misleads them into thinking that markets behave according to the simple logic of the business world in which they have been so successful.

What is really needed for successful speculation is not intelligence but what speculators call an "edge". An edge is a piece of knowledge or a reliable instinct which predicts the direction of market prices and that is not shared by too many other speculators.

You can't get an edge by reading the finance or technical analysis books you bought on Amazon or at Barnes and Noble. The information they contain is fine as far as it goes, but the trouble is that it is information that everone else has too! It can't give you an edge on other speculators. For the same reason you can't get an edge by attending a seminar that promises to reveal market secrets which will lead you to wealth.

Successful speculation requires that you outguess other speculators who are probably at least as smart and experienced as you are. Why do you think you can do this? What special knowledge do you have that few other people have? What's your edge?

If you think about this question honestly you will probably conclude that you don't have an edge. And if you don't have an edge you must not speculate.

SKILL IN SPECULATION

Many people (including most economists) believe that there is no such thing as skill in speculation. More precisely they think that most investment and speculative success is indistinguishable from the result of blind luck. The more dogmatic ones say that Warren Buffet is just lucky, not good. For a good read on this subject I urge you to get Nassim Taleb's terrific book "Fooled by Randomness".

I don't share this view. I think that successful speculators have a tangible skill, although it is not a skill that can be taught. Their skill is the ability to sense the direction in which the crowd ("flock" and "herd" are perhaps more informative images) of other speculators is about to turn, just at the point this turn is starting.

WHAT TO DO IF YOU DON'T SPECULATE?

Read William Bernstein's book "The Four Pillars of Investing" and follow the advice in that book. Bernstein also has a web site.

So take my advice. Don't speculate. And please follow William Berstein's advice when it comes to managing your investments. He knows what he's talking about.

5 comments:

Mike Roznowski said...

Carl,

really informative post, although I doubt it will dissuade anyone from attempting speculation.

I was more interested with your comments on Taleb's Fooled by Randomness, I found it extremely entertaining as well. Obviously you are a successful speculator which flies in the face of most of Taleb's book. What is your response to his thoughts that success in markets can be largely attributed to blind luck?

Thanks,
Mike

Mike Roznowski said...

Carl,

if you find time to reply to mroz78@yahoo.com, i would appreciate it

Thx
Mike

ses01 said...

That skill you refer to is simply understanding your fellow man.

Nidhi said...

Well said Carl .. Speculation is tempting for anyone and to contain it with rationalization would need edge. What do you think this edge is? Gut feeling you get from experience, observation, pattern recognition, etc?

Maybe I will read the books you suggested .. Thanks,

Nidhi
http://creating-wealth.blogspot.com

Royce said...

Wow. This has definately not been my exprience with options trading in the futures markets. I got in small and stay small. I rarely have ever purchased and option with a price above 1000 dollars and always liquidate when I show proffit. Ususally below 100% return on my invesment, sometimes many x more. If I have an option in the wrong position i just let it expire. About 40% of the time they expire. But the winner make up for the loosers and then some.
In my opinion people need to focus more on strategies. If you can't sustain losses in a position you shouldn't have it. That's why I trade options. Don't liquidate just because you've had a few loosing days, all you did is get out with a loss. And don't hold on for the big one because it's moving your way. The markets are fickle. If it turns your way, liquidate and take the profit.