Don't Blame Speculators

Submitted by Larry Frank Sr. on Tuesday, June 5, 2012 - 9:00am
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Speculators are the longstanding villains of investing. Whenever prices rise (or fall) a lot, it is popular to find a faceless force to blame. Somebody must be at fault, and it’s them, skulking around in the darkness, making money off good folks’ misery.
 
In reality, these so-called speculators may make money, but only around the edges. If the stock market drops, they are not the culprits. In economics, a downturn is better explained through the invisible hand of supply and demand.
 
Why has the market dipped this spring, reaching the traditional point of a correction last week (down 10% from the recent peak)? The chief reasons are fears that Europe will collapse and that the U.S. recovery is slowing, on the heels of a bad employment report. That reduces demand for stocks, and more investors want to bail out. The shadowy speculators can’t spawn such a huge, news-driven trend.
 
Rather than point a finger at evildoers, you are better off investing for the long-term (the rest of your life), through the use of passive index funds and prudently allocating your assets to make your psyche better able to withstand squalls as well as good times without large allocation adjustments (i.e., don’t chase returns).
 
Milton Friedman’s explanation of how speculators affect markets is reviewed in a short blog by a professor at the University of MichiganThe take-away: Money-losing speculators destabilize markets, but they can only lose so much. So the speculators who make money help stabilize markets. 
 
The professor, Mark Perry, writes,Bottom Line: If speculators are making money, they MUST be stabilizing markets. If speculators are losing money, they MUST be destabilizing markets. But speculators can NOT make money and destabilize markets at the same time.”
 
A good example is to compare the price swings of oil and onions. Onions, Perry observes, are the only commodity without a futures market (i.e., no speculators). A 2008 Fortune magazine article notes that, in 1958, “onion growers convinced themselves that futures traders were responsible for falling onion prices, so they lobbied an up-and-coming Michigan Congressman named Gerald Ford to push through a law banning all futures trading in onions. The law still stands.”  
 
According to Perry’s calculations, between 2000 and 2011, onion prices were seven times more volatile than those of oil. Somehow, even without evil speculators gaming prices, onions had more price swings.
 
Moral of the story: Speculators are helpful. Some win, some lose, but the effect is to stabilize prices, relative to what price volatility would be without them. This does not mean prices do not go up and down. They need to. It does mean prices go up and down less. This is the fundamental purpose of the futures market.
 
So just what is it that speculators do? Their realm of operation is in the futures market, which is riskier than the stock market in general since the futures contracts expire. Expirations force a gain or loss on the money. Stocks are continuous unless the company goes out of business or reconstructs its capital structure. There are many shades of “speculation.”
 
Larry R Frank Sr., CFP, is a Registered Investment Adviser (California) in Roseville, Calif. He is the author of the book, Wealth Odyssey. He has an MBA with a finance concentration and B.S. cum laude in physics with which he views the world of money dynamically. He has peer-reviewed research published in the Journal of Financial Planning. www.blog.BetterFinancialEducation.com
 
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