In recent years, market bubbles in technology, naked shorting, meme stocks, and a sharp increase in retail investors have all sparked the age-old question of whether speculative investing inherently weakens the stock market’s stability.
Speculation has a malicious undertone to most ears for a very good reason: it has played a part in every financial crisis since modern times. That doesn’t make speculation inherently damaging, but mass speculation, on the other hand, is a fertile ground for financial collapse.
Speculation involves a high calculated risk to gain high returns based on price action, technical analysis, or the expectation of changing circumstances in the future. Most investments are somewhat speculative in nature, with varying levels of risk.
Surprisingly, speculative investing plays a significant role in the economy, but that’s often overshadowed by its potential dangers. Speculators appear in times of high volatility to absorb elevated risk and provide market liquidity by participating when conservative investors bail. The markets need them to nourish new ideas, fund risky start-ups, and drive innovations. Breaking new frontiers in any sector would not be possible without speculative investors bearing high-risk tolerance. Enormous companies such as Microsoft, Apple, and Tesla were all founded on these principles.
Leveraged Speculation
Problems arise with mass or leveraged speculation. As opposed to investors, speculators are not primarily concerned with a company’s fundamental value, only its market price. This leads to detachment from a company’s intrinsic value and into an artificial bubble of expected future worth. With the increased disbalance of more speculators prevailing in the markets, the prices begin to be driven by news that has nothing to do with the companies, causing irrational volatility. This so-called “parasitic speculation” drives money away from useful and needed but less enticing investments.
The birth of modern speculative investing started around the 1960s, with the rise of the growth economy concept being in place today. Capital gains replaced dividends, and speculation exploded in the 21st century, starting in the 1990s. Warren Buffet famously called this phenomenon “a financial weapon of destruction.
Economic bubbles are the most common symptom of excessive speculation. Rapid expansion attracts new buyers, artificially inflating the interest for a stock, and hence its price, creating unreasonable prices and drawing even more buyers who want their fair share of the unbelievable profits. These cycles burst rapidly at a point, leaving investors and speculators alike with worthless pieces of paper and, in some cases, mountains of debt.
This growth-burst speculative cycle has happened several times in the past, with real estate, stocks, commodities, and over-leveraged banks that provided credit to anyone. Aside from the collapse of economic bubbles, other negative effects directly impact the economy and its output. With astronomical stock prices that cannot be justified by output, managers have enormous pressure to focus on unsustainable short-term performance, compromising companies’ long-term prosperity. This phenomenon puts irrational growth expectations on economies, damaging the environment, people, and companies alike.
However, when it is not excessive, speculation can benefit and contribute to a healthy economy. It regulates shortages and surpluses through buying and selling, provides liquidity to markets, takes on high risk by driving innovation, and weeds out unsustainable and inefficient business practices by shorting.