Investing vs. Speculation - The “Spectrum” Mindset
Part IV - Can you set your own speed limits?
Yesterday we discussed another example related to traffic and presented three questions for you to consider:
Why do some people choose to be unsafe when their lives are at stake?
How can we expect to prioritize our financial well-being if we struggle to prioritize our safety when our lives are on the line?
If we mandate speed limits, should we also control excessive speculation?
Today, we will brainstorm and delve into these questions.
Why do people drive at excessively high speeds? One explanation is that some people enjoy the thrill. While this may explain the behavior for a subset of the drivers, we suspect it applies to a smaller group. We believe a more prevalent explanation is that people are in a hurry and/or want to arrive at their destination more quickly. However, as with any aspect in life, there is a trade-off. Drivers who exceed the speed limit are sacrificing safety for time savings. A serious accident can result in losing everything.
We believe another factor in this decision-making process is the perception that the risk of danger is a binary outcome. if no accident occurs, everything is fine, and time is saved. To be clear, we don’t believe there is anything in life worth risking your life for; we are simply attempting to understand the mindset. The minimization of that potential negative outcome is often coupled with overconfidence. Surprisingly, some 90% of American drivers believe they are better than average, which, mathematically speaking, is impossible.
How does this mindset translate to finance? We are not suggesting that individuals who drive fast are bound to be speculators, or vice versa. Rather, we are using driving behavior as an analogy. Why do people neglect safety when engaging in trading? The thrill factor could be one explanation, applicable to a subset of people. However, we believe the majority of people are driven by the desire to make substantial profits. This insatiable desire often leads to compromises and the margin of safety is frequently sacrificed. While it is possible to make significant amounts of money, rapidly, the risk of losing it all increases accordingly.
Another issue is that unsafe driving on the road tends to have binary outcomes, whereas financial losses are not an all-or-nothing proposition. While it may be rare to lose all of your money in the stock market, significant losses are possible. There are no guarantees of recovering these losses over time, either. Consider the Japanese stock market in 1989 for instance: traders who put money in at that time are still underwater today. While it is true that Japan faced serious economic problems, the point is that when safety is disregarded, trading can have long-term repercussions, sometimes even lasting a lifetime.
Paradoxically, those who do not care about money, at least in the short term, often end up receiving it. Graham observed in The Intelligent Investor:
Yet one might argue, perversely, that precisely because the old-time investor did not concentrate on future appreciation he was virtually guaranteeing himself that he would have it, at least in the field of industrial stocks. And, conversely, today’s investor is so concerned with anticipating the future that he is already paying handsomely for it in advance. Thus what he has projected with so much study and care may actually happen and still not bring him any profit. If it should fail to materialize to the degree expected he may in fact be faced with a serious temporary and perhaps even permanent loss.
Reaching a destination a few minutes earlier is not worth risking your life, just as the small chance of making a significant profit is not worth endangering it. If you choose to engage in speculation, go ahead, but do so with the understanding that it is speculation, not investing. Additionally, ensure the capital you risk in speculation is an amount that you can afford to live without.
Is there hope for people who are willing to take substantial financial risks? Can we or should we intervene?
We are pragmatic and do not believe that informing people they are speculating instead of investing will completely eradicate speculative behavior, but it will diminish it. A subset of people, upon realizing they are not truly investing will cease their speculative activities. These individuals genuinely desire to invest but may not have previously contemplated the significance of the words used to describe their actions. Others will disregard the warnings and will continue to engage in speculation.
No harm, no foul. As long as we communicate financial truths and transfer accountability to those individuals, speculation may be acceptable. However, labeling speculative activities as investing is not appropriate. In fact, Congress sought to prevent such misrepresentations. In President Roosevelt’s message to Congress on March 29, 1933, he stated:
Of course, the Federal Government cannot and should not take any action which might be construed as approving or guaranteeing that newly issued securities are sound in the sense that their value will be maintained or that the properties which they represent will earn profit.
There is, however, an obligation upon us to insist that every issue of new securities to be sold in interstate commerce shall be accompanied by full publicity and information, and that no essentially important element attending the issue shall be concealed from the buying public. (emphasis added).
Is there ever a time when excessive speculation is not ok? We do have speed limits in place, after all. If you exceed the speed limit, you will be pulled over and receive a speeding citation. If you significantly exceed the speed limit, you may find yourself in serious trouble. Can a similar approach be applied to finance? What about individual freedom? Shouldn’t it be a personal choice to take on such risks?
The notable distinction between the traffic example and the stock market is that when you drive too fast, you not only put yourself in danger, but also endanger others. Therefore speed limits are mandated for the collective well-being of society. When it comes to financial matters, it is not always evident whether or not trading activities are beneficial to society as a whole. Because the stock market serves a valid economic purpose, it doesn’t make sense to ban it. Regulators can go after speculation indirectly, perhaps by taxing frequent trading, but in the past, those proposals generally did not garner enough support.
What if a particular product invited mostly, or exclusively, speculators? In cases where there is no valid economic purpose, which is what the CFTC determined with election contracts, an outright ban may be justified. Sports gambling used to fall into this category as well, but as a society, we seem to have moved away from that (much more on this later). As for cryptocurrencies, the jury is still out on that but an outright ban seems unlikely.
In general, we believe it is fair to say that the trading environment is becoming more permissive, which is not surprising considering the substantive commissions and compensation it generates for many people. The crucial factor, however, lies in the ambiguity surrounding the word investing. That ambiguity may be beneficial for some, but it is likely detrimental to you.
So whether we should control excessive speculation in the stock market or not is not the most relevant question; it seems unlikely that we will do so. The real question is: What do you want to achieve with your trading? Do you want to be an investor and buy safety or do you simply want to make money via speculation?
Can you set your own speed limits if no one else does it for you?
