How Speculations Can Cause Stock Market To Crash

When it comes to investing, what is speculation?

Speculation or speculating trading is a term used to describe a type of financial transaction in which there is both a substantial risk of losing value and the expectation of a significant gain or other major value. In stock market speculation, the risk of loss is often offset by the expectation of a good return. 

An investor who engages in speculations focuses more on the fluctuation in the price of the stock. This implies that the investor does not fully concern himself or herself with the duration of the stock, ie, whether the stock is short term or long term. The focus is on a positive change in the price of the stock.  

When speculation involves the purchase of foreign currencies, it is referred to as foreign speculation. In this scenario, the major reason why the investor buys the currency is to sell it at an appreciated value and not to use it for settling imported goods or to finance a foreign investment. This basically shows that the focus or goal of speculation is on profit. Without hope for profit, there would be little or no speculation. 

How Does Speculation Work 

A good example of speculation is when an investor buys multiple condominiums of real estate with little down payment with the hope of selling it out when the market value of the real estate increase. This kind of investing is different from buying real estate and renting it out. 

Speculators can provide market liquidity and narrow the bid-ask spread thereby enabling producers two hedge price risks efficiently. Speculative short-selling can be used to keep rampant bullishness in check and prevent the formation of asset price bubbles through the betting against successful outcomes. 

What Is The Stock Market Crash?

A stock market crash is an unanticipated rapid drop in the price of stocks which can extend a bear market for a long period of time and further result in a downward spiral of the nation’s economy. This could be as a result of an unexpected catastrophic event, economic crisis, or the collapse of a long-term speculative bubble. The stock crash can also be as a result of panic among investors. In this kind of situation, panic selling results in a further decline in stock prices. 

Among the numerous market crash that has occurred in the USA, the popular ones include; the 1929 Great Depression, Black Monday of 1987, the 2001 dotcom bubble burst the 2008 financial crisis, and this current 2020 COVID-19 Pandemic.

How Speculations Cause A Stock Market Crash

There is a wide belief that the major cause of the stock market crash is speculations. Speculations are also the major cause of the 1929 stock market crash. This is because, in speculations, investors sometimes borrow the stock or borrow the money used for a down payment. And as the price of a stock begins to rise, more investors want to make use of the period to make as much money as they can. Hence the demand for the stock is higher than the supply of the stock. This further heightens the price of the stock and drives more investors into "speculation." This kind of situation is what is referred to as the "speculations bubble."

In the 1920s, both new and old investors saw a huge 20% return on stock investment. This led to investors withdrawing all the money in their savings account to invest as much as they can. Since most of the investors are trading with borrowed money, it began to result in an unstable economy. 

Due to this, in 1929, industrial production became affected by economic instability. The production of cars and steels started dwindling and fewer houses are being built. These along with the shock caused by the fall in wheat price and in order stock lead to a stock market crash. Stocks started losing value and instead of buying more stocks, investors began to sell their stocks. Hence, a reverse, as there is more supply than demand. Many investors try to sell their stocks as quickly as they can to avoid more losses which further heightened the problem. 

The problem intensifies as panic begins to spread. In fact, it got to a stage that investors don’t bother about how much they are losing but keep selling their stocks. So many people were trading so high that the stock ticker was not able to keep up with the stock price. The price of stock often falls 3 hours or more behind the real-time prices. 

Investing versus speculating

Investing is the act of buying an asset for a long period of time or for a minimum of one year. In speculation, the investor borrows or pay a little down payment for the purpose of selling whenever the price of stocks increase. The duration for speculation is often shorter than that of investment. Also, speculation is sold and bought within the time the stock would mature. The investor who engaged in speculation is expected to refund before the expiration of stocks. 

Investing involves buying and selling of securities such as stocks, bonds, exchange-traded funds (ETFs), mutual funds, and a variety of other financial products. In investors, there is the chance of getting paid by regular dividend returns. 

This is not the case with speculations. Speculations are based on the spread between the cost price and the selling price of stocks. Speculating is like betting that the price of stocks would reduce and be gotten at a price cheaper than it was sold. Though speculating is often likened to gambling, it is not exactly the same. Speculators, unlike gambling, try to make educated decisions on their trades. However, the risk involved in speculation is significantly above average when compared to investing.  

Summary

While speculating can be an effective way for investors to get a quick return on investment, the risk involved is quite high. There is the tendency that instead of falling, the price of speculation can increase. Hence it is better to get involved with value investment than speculations, especially if you are a beginner or an average investor.