Speculation and Investment

Why today’s highfliers are so likely to fall back to Earth


Executive Summary

The signs of speculative excess in the stock market today are obvious. Speculative booms provide both entertainment and outsized profits while they are happening, but they do generally burst painfully. This is particularly true in equity markets, where the demand growth is ordinarily met with increased supply from savvy capitalists. Maintaining excess demand in the face of growing supply becomes ever more difficult and eventually proves impossible. In this cycle, the supply growth is particularly impressive in both its scale and the flexibility it has to migrate wherever speculation is most rampant. That does not seem like a good sign for an extended continuation of this boom. Whether the end means a fall for just the more speculative end of the market or the market as a whole is harder to predict at this point, although even if the rest of the market holds up for now it will require a difficult economic balancing act to keep it aloft indefinitely.

Something odd happened to me the other night. My cellphone rang at 2 AM, from a number I didn’t recognize. I let it go to voicemail, because there was no one I knew in Washington state that had a good reason to speak to me at that hour. I was not put out that the phone had rung in the middle of the night – I had to get up anyway so I could take our new puppy1 out for her nighttime walk. When I woke up the next morning, I was somewhat surprised to see that the caller left a voicemail, which I of course listened to. To be honest, it consisted mostly of expletives, but as near as I could tell the caller is quite angry with me for having suggested that retail investors would be left holding the bag when the market falls. I will admit to feeling a bit honored to be considered consequential enough to be a focus of some random person’s wrath, even if I’m a little confused as to why he singled me out as I hadn’t meant to pick on retail in the way he implied. So, to clarify to whomever it is that I offended by implying that retail investors might be left holding the bag when a speculative bubble bursts, the reason I mentioned retail investors is not because they are uniquely likely to lose money in the bursting of a speculative bubble. Lots of people and entities lose money when speculative bubbles burst. I mentioned retail investors because they are generally the only people who lose money in the bursting of a speculative bubble who are deserving of much sympathy. As the Archegos saga showed a few weeks ago, both sophisticated institutional investors and sophisticated financial institutions are more than capable of losing large sums of money when their speculative bets go bad. It’s just extremely hard to feel bad for them when it happens. When it happens to small investors who lost money they were counting on, however, it is hard not to feel sympathy even if they were doing the exact same thing as the big guys.

As such, I think the call I received was probably unwarranted, but I do apologize if I made it seem as if it is only retail investors who will lose out in a correction. But the event did seem like a nice excuse for me to write a piece on the distinction between investment and speculation and why the stock market is probably a particularly dangerous place to tread when speculative activity starts to overwhelm investing activity. Plenty of books have been written on the topic of speculation, so I’m not going to pretend I will be plowing new ground in musing on the topic over the course of a few pages, but I do want to make a few points. First, while the lines between investment and speculation can be blurry at times, the two are quite distinct activities from a theoretical perspective. Second, speculation is frankly a much more entertaining activity than investing; unfortunately, when the financial markets are capturing the attention of the broader public it is generally a sign that either the market is crashing or that the attention is being grabbed by speculation, not investment. Third, speculative episodes tend to end badly because the goals of speculators are usually unsupportable by the underlying fundamentals of assets. And fourth, that bad end is particularly likely to occur in markets like the stock market, because enterprising capitalists are very good at creating the types of securities that speculators crave. Because maintaining a speculative bubble requires keeping demand perpetually in excess of supply, a growing supply of speculative assets makes the levitation act ever harder to maintain.