Can Diversification Include Speculation?

No matter how we choose to invest, there’s always a little speculation involved. Strict adherents to Modern Portfolio Theory construct portfolios based on estimates—otherwise known as speculations—about future returns, future volatility, and future correlations. Since this is done in a serious way by people with better math skills than most—and certainly me—it’s usually framed as something more precise, obscuring the reality of the underlying assumptions.

Speculators are usually shown in the popular press as either gamblers rolling the dice against a house holding the odds, day traders with a seat-of-the-pants hypothesis, or as individuals throwing money at half-baked concepts. In a genuine speculator’s mind, however, this could not be further from the truth.

According to Doug Casey and John Hunt in their new novel Speculator, it’s all about finding opportunities when the playing field isn’t level.

Recently, I took the opportunity to sit down with Doug Casey at his home to talk about the book and why he turned to fiction after a best-selling career on the non-fiction shelves. And, why he focused on speculation.

But first, take 6 minutes to view the video, and then continue reading.

 Speculator Screenshot


Adding in some detail: mid-way through the novel, the protagonist explains his theory of investing:

“He concluded that it made little sense to risk 100 percent of his capital on conservative investments that might give him a 10 percent return—if he was lucky. It made more sense to allocate 10 percent of his portfolio to speculations that could yield 1,000 percent gains.”

Speculation’s Role In Today’s World
Traditional investment management rarely mentions speculation. In fact, today’s consensus leans towards a conservative diversified portfolio of indexes. The only major public debate is between pure index investing and an actively managed approach (active management being a polite word, of course, for speculation).

But, speculation comes in many forms and has an important place in the investing universe. When someone starts a company, they contribute capital and knowhow for future returns as a form of speculation. Real estate developers speculate that this piece of raw ground will become the next residential community. Mining companies speculate that a particular hole in the ground will prove economical. Individuals speculate that the stock suggested by their retail broker will pan out better than the general market or they follow charts or incantations that will lead them toward success.

Speculation is a part of efficient markets and contributes substantially to price discovery and capital formation. In this case, I am not talking about day-traders, high-frequency-traders, or those who bet by attempting to guess trends or charts. I’m talking about those individuals investing in companies or markets severely out of favor and with a high degree of uncertainty.

Now, what about that playing field…

Traditionally, we like to think of markets as a level playing field. I should have the same access to information as an institutional player. And, from an insider trading law standpoint—all of us acting on the same publicly available information—this may be correct. But, access to information and successful analysis of that information are not the same thing.

Just because the information is available doesn’t mean I have found it.
Proper analysis must necessarily include other relevant information or context about a company not provided directly by that company.
Consideration of an opportunity requires knowledge that is not evenly distributed amongst the population of investors.
Analysis may be biased by the latest popular delusions.

In the broad market for highly traded securities, there are hundreds if not thousands of analysts looking at information on each individual opportunity. On this level playing field, there is unlikely to be any opportunity to “beat the consensus” very often.

Speculation likely works best when the playing field is quite uneven—as Doug notes in the video. Not in the sense of trading insider information, but rather more knowledge about a topic than other investors. Academic research notes that in small-company or fixed-income investing, one can gain an advantage by doing detailed analysis on securities where few others bother to do research. Speculators absorb and integrate information that is not in the daily news in an attempt to gain an advantage.

This is where the hero of the novel, Charles Knight, comes in. Speculator follows the pathway of this young participant in a fictional mining stock. After making a little money early, Knight decides to travel to Africa to assess the company more completely and a multi-continental quest begins for what is right and wrong.

If you like action-packed novels with characters drawn in ethically right and ethically wrong tones, this will certainly keep you enthralled. It is, as Doug says, “a morality tale.”

One Final Thought…
Speculation isn’t for everyone and, in particular, it shouldn’t be done with money that one needs to count on, as there is substantial risk of loss. Over my many years around investors, I have known quite a few who follow the approach mentioned at the top of this article and that is to take a smaller portion of a portfolio and use it to intelligently speculate. Since they were all telling me their story, these individuals were successful. Surely, there were others who lost it all or were forced to drop out.

I enjoyed the action, the characters, and the ethical subscript of Speculator. If you are looking for a good read or a holiday gift, I’ll “speculate” that you’ll love this book. So, visit your favorite bookstore, grab a copy, and dive in.

Until the next Daily Pfennig® edition…

Onward and upward,
Frank Trotter
EVP & Chairman
EverBank Global Markets Group