How Companies Thrive on Speculation

Much like the invention of fire, the development of speculation practices in the modern economy has put a powerful, but potentially very dangerous, tool into the hands of fallible humans. Where fire can be used to warm your home, but can also burn down your house, speculation practices can raise your company's bottom line or put you into Chapter 11. The most successful business strategies usually anticipate some speculation practices as part of a robust portfolio, and some businesses positively thrive on these. It's a good idea to examine how they do that and to keep an eye on the potential for harm to your company, and to society in general, if speculation practices run unchecked.

Speculation is, technically, any kind of investment that's made with the intent to profit from fluctuations in a commodity's price. With such a broad definition, speculation practices obviously embrace a great diversity of investment vehicles. Indeed, to a speculator, the underlying commodity is almost irrelevant as long as its value is rising. This fact introduces tremendous flexibility and liquidity into your portfolio management. The fast pace and quick turnarounds in the market mean that you can be speculating on currency fluctuations on Monday, pork futures on Wednesday, and mortgage-backed securities on Friday.

That's actually a good idea¾caricature though it is. Diversity in your speculation practices helps buffer your portfolio against the inevitable losses. Most of the really profitable speculators in the market are very large institutions, such as banks, that are able to spread out the risk of their speculation practices across multiple instruments and in multiple markets simultaneously. Short selling is a good example of how volume makes the difference between winners and losers here. Say you had information that a certain investment—stock in LousyCo, say—was on its way down. How would you profit from that knowledge? The answer is speculation. You'd go to a short seller, such as Goldman Sachs, and post a bond equal to LousyCo's stock price to borrow a few thousand shares. You sell those shares as quickly as you can and wait. A month later, if you were right and LousyCo has declined, you can now buy back the same number of shares you borrowed, return them to the short seller for a return of your bond, and laugh all the way to the bank. If LousyCo shares increase in value, however, simply forfeit your bond and break even.

The reason this is such a good deal for the bank is volume. With trillions of dollars flowing in and out, a large bank is able to profit from the time value of the bonds deposited. When done in volume, it is quite literally a no-loss proposition for the speculators. As it happens, AIG did manage to get in trouble with its business strategies, mostly revolving around speculation practices, but this was largely the result of its Financial Products division—that is, the speculation desk—getting carried away and encouraging speculators to go long rather than short. The result was so much unsecured liability that AIG was driven under.

When done correctly, as part of a large, balanced portfolio, speculation practices can be a good way to turn profits in the near to middle term. Successful speculators work in the large scale, spread out the risk, and roll with the unavoidable losses. Your business can adopt these speculation practices too¾especially if you can find a high-volume partner, such as a large short seller, to work with.

(Photo courtesy ambro / freedigitalphotos.net)