The Source of Profits in the Business of Financial Speculation
There is scarcely an endeavor awash with more debate, allure, dogma and contempt than the business of financial speculation. The entire investment community is often derided as ‘just a bunch of gamblers’, the most successful speculators are often dismissed as ‘lucky’ and the very pursuit has even been likened to prancing around a fire with two horns on one’s temples. Naturally, we beg to differ. Here, I refute some of these commonly held misconceptions and outline our perception of the rudimentary source of consistent speculative gains.
Is it True that ‘the Speculators are just Gambling’?
It is often said that ‘the speculators are just gamblers’. The likes of politicians may consider this contention to be a closed matter, but for those who are genuinely interested in the truth, there is a great deal to be gained by relatively little thought. After a brief consideration of this prejudice, one surely comes to the conclusion that it is misguided at best and outrightly contradictory at worst.
If this phrase is intended to suggest that speculators are risking their capital purely for the thrill of gallivanting with lady luck, then this statement must fall to the ground. Even though some speculators may be doing this (and such people scarcely remain speculators), the endeavor as a whole exists because uncertainty about the future is an inescapable feature of human life. Man experiences reality through space and time, and the future is always uncertain to him. As Ludwig von Mises wrote in Human Action:
The uncertainty of the future is already implied in the very notion of action. That man acts and that the future is uncertain are by no means two independent matters. They are only two different modes of establishing one thing.
We may assume that the outcome of all events and changes is uniquely determined by eternal unchangeable laws governing becoming and development in the whole universe. We may consider the necessary connection and interdependence of all phenomena, i.e., their causal concatenation, as the fundamental and ultimate fact. We may entirely discard the notion of undetermined chance. But however that may be, or appear to the mind of a perfect intelligence, the fact remains that to acting man the future is hidden. If man knew the future, he would not have to choose and would not act. He would be like an automaton, reacting to stimuli without any will of his own. [Emphasis Added]
Man acts — that is, pursues definite ends by utilizing scarce means — and he inevitably does so into an uncertain future. So, as much as it might please one to think of speculation as an elaborate version of the casino halls, one must come to the conclusion that – as speculation involves prudent ownership of assets through time – it is an inevitable part of the life of men. We all speculate to one degree or the other, and if one considers one’s actions to be entirely and unequivocally non-speculative, then one is surely confused. Again, quoting Mises:
Future needs and valuations, the reaction of men to changes in conditions, future scientific and technological knowledge, future ideologies and policies can never be foretold with more than a greater or smaller degree of probability. Every action refers to an unknown future. It is in this sense always a risky speculation. [Emphasis Added.]
Even if the entire structure of the financial speculative markets were to suddenly evaporate in a puff of smoke tomorrow, the condition that invokes the existence of speculation would remain; the future is uncertain to man.
It may be argued that the condemnation of speculators ‘as gamblers’ is intended to suggest that speculators are risking their capital for propositions that must eventually flounder if repeated many times (similar betting on the roulette table). This, I would contend, amounts to an even greater absurdity! For one, it assumes that the subject matter of financial speculation can be compared to the repeatable and homogenous games of the natural sciences. As Murray Rothbard wrote:
Richard [von Mises], in a probability theory later adopted by Ludwig, demonstrated that it is meaningless to say that the probability of each throw coming up two is one-sixth; what the fraction means is this: if the die is not loaded, and if it is thrown a very large number of times, it will tend asymptotically to come up as a two one-sixth of the time. And the only way you can really make sure that the die is not loaded, i.e., that the two-spot will come up one-sixth of the time is to make the very large number of throws.
The implications for social science — for the study of human action — of the contrasting theories are profound. For, if one holds to the objective Mises theory, it is unscientific and illegitimate to apply probability theory to any situations where the events (like the tossing of a die) are not strictly homogenous, and repeated a large number of times. And since, outside of die tossing or roulette, all the events of human action, economic or political or in daily life are clearly not homogeneous and therefore not repeatable, the Mises view demonstrates that all use of probability theory in social science is illegitimate. [Emphasis Added.]
The speculative financial markets deal with social matters which are certainly not repeatable, homogenous events (as they are perceived and involved with the human interplay).
But even if the condemnation of ‘speculators as gamblers’ isn’t meant in the sense of comparing their subject matter to natural, homogenous and repeatable games, there are still problems. That is, even if people are not comparing speculative activity to gambling on a die, their condemnations are still contradictory or misguided. For one, any such condemnation of a speculator ‘betting on the improbable’ presupposes some kind of probability distribution with respect to the future. The immediate question becomes;, how is one to condemn the activity and intent of speculation when one is presuming speculative knowledge oneself? Secondly, this kind of condemnation misses the point that the speculative markets are filled with buyers and sellers – for every buyer there is a seller. So, if one were to condemn a specific speculator for ‘gambling’, then one cannot help but simultaneously endorse and congratulate the person on the other side of his trade! Therefore, one can hardly condemn ‘speculators’ as such without escaping into one’s personal fantasy!
[What about the morality and social utility of financial speculation? I highly recommend listening to the following chapter from Walter Block’s book, Defending the Undefendable:
Our Opinion on the Source of Speculative Gain:
Ok, if you’re still here, I’m guessing that you’re at least partially convinced that the endeavor of financial speculation is neither ‘gambling’ as such nor ‘evil’. So what exactly is it then? And what is the root (assuming that one can identify it at all) of consistent gains in financial speculation?
Rather than ‘comparmentalizing’ this business into something completely separate to all other money-making endeavors, I would like to consider — if just for a moment — how any money making venture succeeds. If one really thinks about the rudimentary way in which anybody makes money consistently, one must conclude that it is service to one’s fellow man that is behind it. Correct anticipation of what people want (but are unwilling and/or unable to do at a given price) seems to be the rudimentary source of entrepreneurial profit.
Are we to assume that the business of speculation is any different? Financial speculation involves holding assets through time to an uncertain future. In short, it involves preparing a future that is unknown. However, all men act, and all men are subject to an uncertain future. To different degrees, all men have to engage in such speculation.
So, in which manner can a speculator serve his fellow man? Our contention is that he can do so by considering and preparing for that which others are unwilling and/or unable to prepare for. In terms of ‘unwillingness to consider a future’, the speculator can seek gains by escaping the pull of group thought, identifying the mood, and looking in the realm of the opposite for speculative opportunities. With respect to ‘inability to consider a future’, we would contend that the speculator can seek gains by understanding that which the majority of men fail to understand. [Incidentally, this is why we spend our time studying currency systems here at greshams-law.com rather than eagerly following every piece of news that comes out every minute!]
This – of course – is not new, and not revolutionary. It is what has been said by virtually all successful speculators over the past several hundred years! This is none other than the contrarian principle. After all, near the ends of long bull trends, optimism spreads far and wide and nobody cares to consider (let alone prepare for) undesirable prospects. Indeed, bad prospects become so subordinated in the minds of men, that they can scarcely conceive of them. Conversely, near the ends of long bear trends, pessimism spreads far and wide and it is a positive future that becomes inconceivable to men.
Financial speculation is not ‘gambling’ as is often proclaimed in public pronouncements. Neither is it evil or malicious. Our contention is that the root of speculative gain lies in considering that which others do not care to prepare for.
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012