Saturday, February 21, 2009

On Speculation

Over a long time, I have rarely met people who are mentally immune from financial markets (especially the stock market). It has become a routine thing for many middle class professionals to try their luck in stocks. After few hits and misses and a significant magnitude of loss he gets scared and tells everyone how bad the stock market is! The listener thinks the narrator is inept and he can do a much better job than him but ultimately suffers a similar fate. It has become a story of every household of how someone they know have lost money in stock market yet the fresh crop is always ready for mowing.

The "green outsider" (as Jesse Livermore calls) gets in stock market to make some quick and easy bucks. It doesn't take very long for this type of person to realize that stock market is one of the toughest places to preserve money (leave alone growing it). After every loss he starts blaming stock market/speculators/traders who collectively swing the market (sometimes on contradictory reasons). For example: On February 6th 2009 the unemployment report shows a record number of job losses and Dow Jones rallied 217 points. The purpose of this post is not to describe why it rallied but to shed light on some aspects of speculation.

The word speculation has become a taboo in modern society. Indeed there is a lot of moral hazard in speculation and so is the case with any price movement (such as rise in real-estate prices). Before proceeding further let us look into the definition of speculation. As Bernard Barush puts it: speculation is derived from the Latin word speculari which means to spy or observe. Speculation is an action based on observation and investigation. There is an element of speculation in everything. Sometimes the amount of speculatory element in an action/decision is extremely enormous and often downplayed as a logical decision. For example: A teenager decides to pursue his career in Chemical engineering. The observation here is that current chemical engineering field is lucrative and is offering high paying job. The speculatory element (that chemical engineering will continue to be lucrative) is so enormous here that he decides to spend 4 years (if not more) for understanding and studying the profession. I can go on and on about describing the speculatory element in our day to day activities but for the sake of brevity I will leave it here by saying every action in our life is based on observation and thus can be classified as speculation.

Speculation in financial market is often equated to gambling. Indeed there are similarities and differences. The similarity is that both involve putting capital at risk. The difference is: speculation involves risking your capital when odds are in your favor whereas gambling is taking risk when odds are stacked against you. There is no such thing as a DEFINITE return in financial world. Everything from bonds to futures involves putting capital at risk and chances of loss are always there. This is also the case with any business in this world. For example, if you open up an ice factory chances are that you might suffer loss due to numerious reasons. In this sense, speculating in financial markets is no different from investing in say a friend's company which makes ice (lets call it the main-street business). But there are differences.

The key differences between actually investing in a physical business and stock market are:

1) Frequency of capital appraisal: In financial market it is done everyday and in many cases every second (of business hour) whereas in a main-street business it might not be done for years (the maximum you get to know is the book value of the business).

2) Participants: The number of participants are huge in the business (which trades on stock exchange) compared to the same business on main-street. Not only this, the financial ability of these participants is enormous compared to the main-street business participants.

3) Ease of getting in and out: In financial markets you can buy and sell ownership by a mouse-click whereas in main-street business it is relatively difficult to get your stake back.

4) Response factor: Stock markets respond fast to changes in general condition compared to their main-street counterparts.

5) Pricing method: Like I mentioned above the main street business's value is vague and can only be estimated by its book-value. A single stock of the same kind of business is based on book value + anticipatory element.

It is not hard to judge after looking at the differences as to why the chance of success in stock market is thinner than main-street business.

The single most important danger in stock market is the heuristic nature of buying-price(entry point). Markets are always changing. Prices move. It is not possible for anyone to know the actual value of the stock. And the fact is there is no actual value of a business. People use different measures like book value, price to earnings ratio, price to sale ratio. But all these terms are very frequently violated. In recessions many stocks trade below its book value. The primary reason is book value itself is ambiguous. Book value is derived from the prices of assets which themselves are based on speculation. It is beyond comprehension how a stock that was not available at a P/E of 50 in bull market becomes undesirable at PE of 20 in bear market.

The next reason (which is a corollary of first reason) is that the frequency of capital appraisal. This high frequency creates fear/anxiety/greed among the participants. One should read Theory of Reflexivity by George Soros to see how reflexivity works in financial markets. The response factor due to these emotions goes above the brink.

The "green-outsider" doesn't bother to pay attention to this. He doesn't realize the extreme difficulty in deciding the entry price. All he needs is a tip from a friend and an internet
connection and he becomes an owner of something which might be (and many time it is) worth less than what he paid for. He tries to bottom-fish a stock which has fallen from cliff thinking he knows the value of the company more than anyone else in this world (although in many cases he doesn't even know where the company is headquartered). As Livermore puts it: A man does more due diligence in buying a small appliance for his home than he does in buying stocks.

I am sure many people lose money in main-street business too. The rate of failure might be a little low because the participants do more due diligence before handing over money to main-street business men. But the percentage loss of capital when a main-street business fails is much larger than the stock market losses (due to lack of transparency). Also, if the main-street business fails, the participants know about it a lot later from his entry into investment (in stock market the investment anxiety starts right from the entry point and remains constant).

2 comments:

H said...

So the bottom line is .. learn to recognize yourself as a green-outsider and stay out of it? :)

Salman said...

I think outsiders stand a better chance of success in financial world if they realize the seriousness of the field. That’s the reason why successful hedge funds like Renaissance, Quantum funds etc. seek people with no Wall Street exposure. The problem however is that many outsiders lack sincerity and just want to test their luck in stock market.