How To Avoid Speculation In Shares And The Forex

Posted by Nick Niesen on October 29th, 2010

In the vocabulary of investment, "speculation" is a nasty word.

It suggests gambling, insecurity, long shots, luck, and similar improprieties. For old campaigners it stirs up memories of the 1929 unpleasantness, as damp weather tweaks the rheumatic joint. And, worst of all, it seems synonymous with money lost. For every speculator who pulls a coup, we hear, there are 99 who live to rue their recklessness, to bemoan the hard-earned dollars foolishly and irretrievably cast down the drain.

The New York Stock Exchange labors long and hard to encourage a sober, sensible attitude in investors. Conscientious brokers steer their customers away from situations bearing a speculative tinge. The literature of investment inveighs against empty-headed avarice, blind faith, and other vagrant impulses that lead the innocent into ill-starred ventures.

If fear breeds caution, all well and good. For speculation can be extremely hazardous, particularly for the new investor, which means in most cases the person who can least afford it. And certainly speculation, as it involves cheap, shadowy gold-mining or uranium stocks, is little better than throwing dice or picking horses.

But speculation is a term of many dimensions, and it is useful for investors to understand them, rather than simply bow to the taboo

By the more conservative canons of Wall Street, for instance, investment in anything except the highest grade bonds is speculation. This is strict interpretation of the dictionary definition of the word as an undertaking in which a large risk is borne in the hope of a large profit. In this sense, almost any common stock, dependent as it is on net earnings, entails some risk, some speculation.

This is fairly rigid doctrine, however. It is a premise of this article that with care and attention the investor can find satisfactory common stocks as free of risk as any other form of property in an uncertain world. It then comes down to a question of the investor's objective.

The investor, by and large, is in for the long pull. The speculator, characteristically, is a short-term, quick-turnover man. He is interested in speculative situations and makes use of speculative techniques.

Many of them are commonplace. All of them are legal. But they usually require more capital than the new investor can bring to a transaction and they invariably demand shrewd judgment, complete familiarity with market procedures, and considerable nicety of touch in the timing of purchases and sales. In expert hands, they are useful tools for the creation of wealth. In the hands of the novice, they are?as Samuel Goldwyn said of the H-bomb?dynamite. They should be understood?and avoided.

Buying on Margin

Perhaps the most familiar speculative technique is buying on margin, which is utilizing credit, in the form of a loan, to acquire more stock than your cash-in-hand will purchase. Let's say, for instance, that you have $4,500 and are interested in a stock selling at $50. Ordinarily, of course, the most you could buy would be 90 shares.

Through margin buying, however, you could borrow an additional $500 from your broker and get 100 shares.

Is this good? Well, it's not bad. The 10 extra shares give you an increased equity, 10 more shares on which to realize a market gain. You will also get perhaps $20 or $30 in additional yearly dividends.

You have saved $20.50 in fees and commissions, since the cost of a round lot is only $44, while a 90-share odd lot is $64.50?$42 for the broker and $22.50 (¼-point or $.25 a share) to the odd-lot dealer. And, finally, your $500 is obtained on a call-loan basis, which means 4- to 6-per cent interest (depending on how big and active your account is) and no particular payoff date. Even at 6 per cent, your interest charge would be only $30 a year, an amount quite possibly covered by the dividends received on the extra shares acquired.

The advantages of margin buying, while interesting, are not in this instance impressive. This is because the so-called "margin requirement"?the amount of cash the buyer must put up?is determined by the Federal Reserve Board and at present is pegged at 90 per cent. In other words, you can borrow from your broker no more than 10 per cent of the dollars involved in any single transaction. The margin rate is variable, and is used by the Board to help maintain the stability of the market. At the higher end of the scale, margin acts as a brake on speculative or inflationary tendencies. At the lower end, it represents a loosening of credit and acts as a spur and an encouragement to investment when money is scarce.

The lowest rate ever permitted by the Board was 40 per cent, which was in effect between 1937 and 1945. Here, of course, was a period that began with two recession years, picked up briefly, and then was arrested by World War II. Taxes rose, capital was elusive, and profits were restricted. To coax money into the market place, a low cash requirement and a high borrowing capacity were allowed.

By 1946, however, conditions had changed. The postwar boom was beginning. Money was plentiful, goods were scarce, and the inflationary pressures were building. For thirteen months, from January, 1946, to February, 1947, the Board held the margin requirement at 100 per cent.

At lower rates, margin buying becomes quite attractive. If you had had your $4,500 to invest during the 40-per cent period, you could have borrowed the other 60 per cent? $6,750?and acquired 225 shares of $50 stock, instead of 90. On a $2 return, your dividends would be $450 a year, rather than $180. But more important, if there were a 10-point rise in the stock to 60, your 225 shares would bring $13,500. Paying back your $6,750 loan and subtracting your original $4,500 investment, you would have a profit of $2,250 (less commissions). The same 10 points on 90 shares would increase their value to $5,400, or only $900 more than you started with.

A fat capital gain like this is the real point of margin buying. A 10-point rise is not too difficult to find in a bull market. It is quite possible for the speculator to be in and out before the interest on his borrowings amounts to more than a few dollars. In such cases, he has had virtually a free ride.

Forex is quite speculative as well, but to help you avoid heavy losses and maximize your gains it is well worth downloading some of the excellent Forex software that is available.