The Art of Incorporating Speculation In Your Investment Strategy

For me, watching the news is like watching a sport. I do it for entertainment, not to actually learn something. What’s most entertaining for me is watching politicians talk about things they have no understanding of… or completely misunderstand… like when President Obama or his advisers try to predict the economy, especially the stock market.

My favorite comments come from speeches they make about “evil speculators” driving up gas prices, or “unpatriotic short-sellers” who “cause” price collapses in share prices—as if speculating and short selling were evil by their very nature.

We all know what speculation is—gambling on the future price of an asset (via a stock, ETF, bread, gas, anything else) in hopes of gaining after a favorable price movement.

So let’s cover "short selling", which based on feedback and questions I get about this topic, a lot of you don’t understand.

But you understand iPhones, right? We'll use them to explain what short selling is.

iPhones and Short Selling

If you own an iPhone, you likely know that a new one comes out every fall. And people line up for hours at their local phone outlet and scream, “SHUT UP AND TAKE MY MONEY.”

Let’s say it is August, and you anticipate Apple releasing a new iPhone model within the next couple of months. You have a friend leaving the country for a couple months where they can’t use their iPhone, so they give it to you to “use.”

But you already have an iPhone, and you know a way to take advantage of your extra one.

You know for certain that once the new iPhone model comes out in a month or so, this particular model will be worth a little less—it will soon sell for a discount to the current price. Anticipating this imminent price drop, you “borrow” your friend’s iPhone (which you don’t actually own), and sell it for $250—market value—to some poor sucker who apparently needs an iPhone very badly.

A month goes by. The new iPhone is out… and the guy who bought the iPhone from you now wants the newer model. Since you really need to get the phone back to your friend soon anyway, you agree to buy back the iPhone from this sucker… at its new market value of $200.

What just happened? You borrowed the iPhone from your friend… sold it for $250… bought it back for $200, realizing a $50 profit, and now have the iPhone back ready to deliver to your friend.

Short Selling Is Buying Things On Sale, Anticipating a Price Increase

Whether or not you realize it, we all do this all the time in a similar way… just in the opposite direction.

It’s called “shopping when something is on sale.”

If milk is on sale, or if you knew the price of a gallon of milk is going to double soon, you’ll run out and buy up a few to hedge against price increases, won’t you?

Is that immoral? Is that evil?

By the way, when you bought that milk ahead of the price increase, you just speculated on price. The price of milk could just as easily go down, and you’ll “lose” money because you could have waited and bought cheaper…but it’s highly unlikely. That’s why you took action.

Let’s bring this discussion back to investing. Short selling involves borrowing shares from your broker at a the current price and selling them in the market, then buying them back later. If you buy them back when the price is lower than you sold them, your broker pays you the difference and you have turned a tidy profit.

There's nothing immoral or wrong about any of this. It's a system designed to be used for profit.

Be cautious: it works the other way around, too. If you sell the shares short, then buy them back when the price is higher, you lose money—you pay the difference. It’s like when you bought the milk, thinking the price was going to increase, but really it decreased, and if you had waited, you could have actually gotten a better deal.

Short selling, speculating, etc… these are just alternative ways of investing, in order to ensure you profit whether the market goes up, or whether it goes down… you can also profit from a sideways market, when things are not going in any particular direction. More on that works here, and a specific example of it here.

There's Nothing Evil About Using a Legal System to Win At Investing

Any discussion you ever hear on television from politicians about “evil speculation” and “unpatriotic short-sellers” is all hyperbole (i.e., obvious exaggeration). Don’t buy into it. The notion that it’s “evil” or “unpatriotic” when someone sees a stock market correction coming and profits from the fall (by short selling) is just as ridiculous as the notion that someone profiting from its increase is an evil demon. After all, we love to see our 401ks increasing in value, right?

This kind of talk by politicians is targeted to invoke a reaction from the public against an interest group that the politicians would like to marginalize. It’s designed to incite anger and sway public opinion to lay blame on a set group of people just doing their jobs—rather than those really causing the current problems, the central banks.

The most recent “unpatriotic devil incarnate” the government is pointing its finger at are companies undergoing tax “inversion,” or the process by which a US company changes domiciles to a foreign country in order to avoid paying outrageously high future US corporate taxes. Corporations like AbbyVie and even—gasp—the all-American Burger King are now demons in the eyes of finger-pointing politicians. As if minimizing tax burden was a cardinal sin—we all do the same by claiming dependents on our taxes.

The bottom line is—stick with me. I try to leave out hyperbole (again, obvious exaggeration), unless it's warranted.

To sum up, short selling and speculation are not evil, as politicians and economists might try to make you think. Just like any investment strategy, they do involve risks. But if executed at the vertex of maximum optimism/pessimism and ultimate pandemonium (i.e., imminent blood in the streets), they serve as good methods for hedging any investment portfolio.

Live Long and Invest,

Jeremiah