2.

Speculation

According to Philip Carret, author of “The Art of Speculation” in 1930 and founder of one of the
first mutual funds in the United States, speculation is the “purchase or sale of securities or
commodities in expectation of profiting by fluctuation in their prices.” Garret combined the
fundamental analysis popularized by Benjamin Graham with the concepts used by early tape
readers such as Jesse Lauriston Livermore to identify general market price trends.

Milton Friedman, writing in In Defense of Destabilizing Speculation in 1960, noted much of the
public equates speculation with gambling, with no value as an investment philosophy. However,
Friedman contends that speculators often have an information advantage over others, enabling
them to make profits when others less knowledgeable lose. In other words, speculation could be
defined as the buying and selling of securities based upon a perceived advantage in information.

Paul Mladjenovic, a certified financial planner (CFP) and the author of four editions of “Stock
Investing for Dummies,” explained the point of speculation best: “You’re putting your money
where you think the rest of the market will be putting their money – before it happens.”

Jesse Lauriston Livermore, named the “most fabulous living U.S. stock trader” in a 1940 TIME
article, developed his skill buying and selling stocks in bucket shops – unregulated businesses
that were the equivalent of today’s off-track betting parlors, where customers placed wagers on
the price movement of stocks, according to Bloomberg. No securities changed hands, and the
transactions did not affect share prices on stock exchanges. Livermore’s ability to detect and
interpret patterns in the movement of stock prices quickly made him persona non grata in the
shops, much like card counters are banned from the casinos of Las Vegas and Atlantic City.

But Livermore’s focus on stock prices and the patterns of their price changes enabled him to
identify “pivot points” – now known as levels of support and resistance – that guided his buys
and sells. He purchased stocks as they rebounded from a support level, and sold them when they
approached a resistance level. Livermore understood that stocks move in trends, but could
quickly change direction depending upon the mood of stock market participants. Accordingly, in
his book “Reminiscences of a Stock Operator,” he advocated a strategy of quickly cutting losses
and letting profits run.

Other Livermore stock trading rules include the following:

 Buy rising stocks and sell falling stocks.

 Trade only when the market is clearly bullish or bearish; then trade in its general direction.

 Never average losses by buying more of a stock that has fallen.

 Never meet a margin call – get out of the trade.

 Go long when stocks reach a new high; sell short when they reach a new low.
Livermore also noted that the markets are never wrong, though opinions often are. As a
consequence, he warned that no trading strategy could deliver a profit 100% of the time.
Livermore and others following a similar philosophy are willing to be on the sidelines – out of
the market – until an opportunity for profit is readily apparent.

The techniques used by Livermore evolved into what is now known as technical analysis
by extending Livermore’s pivot points to more esoteric price and volume patterns of price
changes such as head and shoulders patterns, moving averages, flags, pennants, and relative
strength indicators. Technicians led by John Magee and Roberts Edwards – authors of what
many claim to be the bible of price speculation, “Technical Analysis of Stock Trends” – claim
that the bulk of information which “fundamentalists [investors] study are past history, already out
of date and sterile, because the market is not interested in the past or even in the present! In brief,
the going price, as established by the market itself, comprehends all the fundamental information
which the statistical analyst can hope to learn (plus somewhat is perhaps secret from him, known
only to a few insiders) and much else besides of equal or even greater importance.”

The underlying assumption of speculation or technical analysis is that patterns repeat themselves,
so a review of past and current prices, properly interpreted, can project future prices. The
assumption was challenged in 1970 by Eugene Fama, professor of finance at the University of
Chicago and a Nobel prize winner, with the publication of his article “Efficient Capital Markets:
A Review of Theory and Empirical Work” in the Journal of Finance. Fama proposed that
securities markets are extremely efficient, and that all information is already discounted in the
price of security. As a consequence, he suggested that neither fundamental nor technical analysis
would help an investor achieve greater returns than a randomly selected portfolio of individual
stocks.

His ideas became popularly encapsulated as the Efficient Market Hypothesis (EFH). While
acknowledging critics of EFH, Dr. Burton Malkiel – economist, dean of the Yale School of
Management, and author of “A Random Walk Down Wall Street” – defends the hypothesis. He
claims that stock markets are “far more efficient and far less predictable than some academic
papers would have us believe…[the behavior] of stock prices does not create a portfolio trading
opportunity that enables investors to earn extraordinary risk-adjusted returns.”

While the academic battle over EFH continues, adherents of technical analysis – speculators –
continue to embrace the philosophy as the best method to pick optimum moments of buying and
selling.