Risk Markets And Politics

Thursday, June 16, 2005

Speculators

On the one hand, the word "speculator" is associated with the far-sighted sage, who prudently stores goods in times of plenty to later rescue society during crises and famines, concomitantly, buying low to sell high. The archetypical speculator of this kind is Joseph, who foresaw seven years of plenty followed by seven years of famine and advised the Pharaoh to store food accordingly.

More often though, speculation is synonymous with bad speculation, especially with the reckless buying that occurs in bubbles. This speculator, who buys high to sell still higher, is seen as short-sighted and liable to introduce volatility, as opposed to the noble speculator who instead buffers instability by taking more contrarian, independent, positions. This second type of speculator is, at best, naive, perhaps a "mere" gambler, and possibly downright malicious. An argument could be made for the philosopher Thales of Miletus being put into this category. If the story can be believed, Thales, through his skills in predicting the weather, anticipated a particularly large crop of wine grapes and went about accumulating (cornering?) wine-presses early in the year, thereby aggravating their shortage relative to grapes.

You see, Thales didn't "need" so many wine presses, and likewise, speculating is sometimes opposed to using. For example, in real estate, "flippers" are speculators, whereas the couple buying a home to raise their family would be considered users. Of course there is nothing preventing individuals or specific decisions falling under both categories to one degree or another, especially over time. Bertrand Roehner has proposed the "speculative ratio" metric, which is the number of speculators divided by the total number of market participants (speculators + users, or the ratio could be calculated on a capitalization basis). He notes that real estate markets typically contain 20% speculators, and that the speculative ratio of a stock market is 100%. It is in fact very high but not 100% as Roehner claims; this forgets the voting rights which are sometimes critical!

Users are like hedgers. The hedger has a risk that he wants to insure against, and the speculator buys this risk. This sense of speculator most closely corresponds to the one I have used below. Once again, this distinction is often unclear as hedgers often speculate and vice-versa, but this doesn't mean that the concept is useless, and perhaps it can be re-cast in a more precise way. Specifically, by "hedger" I mean someone for whom the market activity is secondary to some other activity (often in another market or business), and by "speculator", someone whose activity is primarily an activity in that specific market. The distinction is therefore relative; the speculator's activity is, of course, most probably secondary to some other activity or goal in his life, but in any given trade, one party is the relative speculator and the other the relative hedger.

The point (yes there is one!) is that speculators tend to prefer markets not dominated by other speculators. In most cases, larger dispersions in needs, perspectives and time-frames of market participants cause larger inefficiencies and more opportunities for profit.

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