"We find that whole communities suddenly fix their minds upon one object and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first."
- Charles MacKay, "Extraordinary Popular Delusions and the Madness of Crowds," 1841
Speculation has always been a fundamental urge innate to the human species, but it is rarely recognized as such except in hindsight. The number and frequency of TV commercials for cryptocurrency exchanges during the World Series should remind us of the Dot.Com mania, whose zenith and collapse were foreshadowed in the Super Bowl ads of 2020. Even the umpires are festooned with logos for FTX, another electronic bazaar for crypto coins. The very notion of "investing" in cryptocurrency is an oxymoron, but rather embodies the essence of speculation.
Speculation is not a dirty word, and many instruments like those that allow producers of commodities to hedge their risk depend upon a willing pool of speculators to take the other side of a contract. But individual investors frequently have difficulty distinguishing between investment and speculation, which can lead to potentially devastating losses.
Benjamin Graham was the progenitor of systematic investment analysis whose protégé Warren Buffet went on to garner some renown of his own. Graham's definition of an "investment operation" was "one which, upon thorough analysis, promises safety of principal and a satisfactory return." Admittedly, Graham wrote in 1934 in an era of high-quality railroad stocks that generated consistent dividends, but the same basic principles apply to investing today: minimize risk to the level necessary to obtain a satisfactory return. In modern jargon, we use the term "required return" to represent the expected level of profit an investor must expect in order to move money out of cash and into the investment. Graham's "safety of principal" is generally regarded now as the degree of variability or "volatility" the investor can withstand, understanding that risk cannot be completely eliminated but that over time, the value of a broadly constructed and diversified basket of securities will gain steadily but undramatically.
It should be evident that the primary distinguishing factors between investment and speculation are risk and time. Individual investors are generally best served by concentrating on diversified holdings of ETFs or mutual funds, or by engaging a professional asset manager to provide analysis and portfolio management. Individuals can fine tune their holdings to their own particular risk tolerance by altering relative proportions allocated to safer "blue chip" stocks and bonds versus riskier, higher-octane sectors like small companies and foreign funds in controlled proportions that are frequently rebalanced.
Speculation resides at the opposite pole. Ben Graham considered speculation to be anything other than investing, but a more meaningful definition must incorporate risk as follows: the purchase and sale of assets that carry a high probability of substantial or total loss but also offer the possibility of outsized gains. Speculators tend to focus attention on high-risk, high-payoff ventures in the hope that their home runs exceed their strikeouts. Speculators may commonly be seen trading in options and futures markets, but can be found pursuing penny stocks, short selling, and day trading based upon historical charts (or divination by inspection of entrails). Speculators sometimes also use leverage to magnify the impact of their bets.
True speculators are comfortable with substantial risk and frequently experience significant losses. It is when "investors" are drawn into speculation without their own awareness that danger arises. In his 1841 study of the psychology of crowds, Charles MacKay included three chapters on financial manias whose bursting inflicted serious pain on individual investors drawn into popular speculations of their day. Today's crypto mania, with its associated media hype and the introduction of ETFs to entice ordinary investors into gambling on Bitcoin, bears many of the hallmarks of a speculative bubble. So too does the frenzy in "meme" stocks driven to preposterous prices by cheerleaders on Reddit and Robinhood. Human nature, it seems, is immutable.
Prudent investing for future goals like retirement is essential and need not be overly complicated. A simple, disciplined, long-term plan can help individuals avoid speculative mistakes and stay in the "investor" lane. The hardest part can be recognizing our psychological biases and resisting our primal instinct to enter the casino.
Another nearly universal aspect of speculative bubbles: they become patently obvious only after they pop.
Christopher A. Hopkins is a chartered financial analyst in Chattanooga.