Quote of the Day: Speculation vs. Gambling

Today’s quote of the day comes from Chapter 12 – Investment and Speculation in Thomas Sowell’s Basic Economics: A Common Sense Guide to the Economy*, one of my favorite books:

Speculation is often misunderstood as being the same as gambling, when in fact it is the opposite of gambling. What gambling involves, whether in games of chance or in actions like playing Russian roulette, is creating a risk that would otherwise not exist, in order either to profit or to exhibit one’s skill or lack of fear. What economic speculation involves is coping with an inherent risk in such a way as to minimize it and to leave it to be borne by whoever is best equipped to bear it.

He uses the example of a wheat farmer and futures contracts to illustrate his point:

A futures contract guarantees the seller a specified price in advance, regardless of what the market price may turn out to be at the time of delivery. This separates farming from economic speculation, allowing each to be done by different people, who specialize in different economic activities. The speculator uses his knowledge of the market, and of economic and statistical analysis, to try to arrive at a better guess than the farmer may be able to make, and thus is able to offer a price that the farmer will consider an attractive alternative to waiting to sell at whatever price happens to prevail in the market at harvest time.

Speculation serves a purpose in that it reduces risk in the economy as a whole.

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7 thoughts on “Quote of the Day: Speculation vs. Gambling”

  1. Thats fine as long as the “speculators” use their own money, not like MFGlobal who gambled away customer money. Oops, did I do that? Oh well, give me a slap in the wrist before I walk away with my millions…

  2. I don’t get your final point. It doesn’t reduce risk in the economy as a whole. It reallocates risk to people who business it is to purchase risk and lets market participants whose expertise is in other areas to focus on those other areas.

  3. hal p) Not sure your comment was for me, but if it was:

    The customer money is not to be used to prevent the investment company from going bankrupt.

    It would be like Fidelity declaring bankruptcy and telling you your 401k balance is now zero. That is just theft, yet that is what happened at MFGlobal and not a single charge has been filed against Corzine or the other officers.

  4. Hal,

    I think overall, speculation as defined by Thomas Sowell, does reduce overall risk as long as it’s done safely without too much leverage. I think that was the point that Dr. Sowell was making (that’s where I got that sentence in the first place).

  5. I would say that speculators help to better find the “fair market price” — in theory. In reality the hyper traders give a false perspective of the market (ala flash crashes are going to happen).

    Its like you going to a small shop to negotiate a price for an item and 10,000 other people show up to bid when they have no intention of actually producing or buying/keeping the item in question.

  6. Speculation in the context of commodities, sure. They are very useful for managing risk for both the producers and consumers.

    I see no such global benefit in stock option trading.

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