Speculation: A blessing in disguise!

We take many decisions in our day to day life, without really knowing the outcome of those decisions. There is always a probability of success or failure of that decision. For example, during the rainy season, we have to take a decision whether to wear a raincoat or not, based on our expectation whether or not it will rain during the day.What exactly is speculation? Speculation in respect of the financial world includes the buying, holding, selling, and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives or any valuable financial instrument. It is different from buying because a speculator does not buy goods to own them, but to sell them later. The reason is that he wants to profit from the changes in market prices. Speculation is one of the market roles in  financial markets. The others are hedging, long term investing and arbitrage. Speculators do not plan to keep an asset for a long time.

Common features of non speculative markets are:

• Almost total absence of leverage, and has limited depth
• Shares, bonds and other assets are bought primarily for cash and not on credit
• The expectations of capital gains are low
• Trading volumes are low, and trading is dominated by a small group of people.
• The markets are traditionally undervalued markets

A majority of the Asian markets, including India were non-speculative markets till the 80's. In India, in the 70's and 80's people bought homes only to live in them. Gold & silver held by the families were non-speculative in nature. With the globalisation of asian economies an element of speculative interest has been built in these markets. There has been a lot of interest in these markets from the foreign investors largely because of the huge growth potential, as most of these markets had been depressed for long, because of the lack of speculation. The Asian markets led by China and India are currently going through a long term "bull phase", which is marked by higher speculation.

According to John Templeton "Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria.” An investor should not be unduly worried about the higher volatility in our markets, because just like small cap growth stocks tend to be more volatile than established blue chips, emerging markets tend to be more volatile than matured western markets. But then they also have the potential to deliver higher returns.

However, investors must be aware of the speculative excesses, which often cause the end of bull markets. Here are some of the symptoms of speculative excesses:

• The long the uptrend in the market, the higher is the likelihood of creation of a mania or 'herd instinct'. Long term bull markets survive only if there are intermittent corrections within the bull run
• In the maniac phase of the bull market the mood is euphoric, and even dud stocks rise appreciably
• The number of new issues is very high
• The mania is whipped by the media, because their business survives on creating the hysteria.
• Towards the end of the maniac phase, insiders resort to double standards - painting a rosy picture about their businesses in public but paring their holdings in the company
• Sometimes it results in surfacing of 'Ponzi schemes' and 'Swindlers'. The likes of Harshad Mehta and Ketan Parikh are the creations of the excessive speculation phase.

Sir Isaac Newton amply sums up this frenzy when he says: “I can calculate the motions of heavenly bodies, but not the madness of people”. Speculation is good for the markets, untill the above symptoms appear. Investors can safely ride the current long term bull market in India, but must guard against the above factors to protect their interests.