Everyone is a Speculator

Speculation: the practice of buying assets that incur risk to the speculator with the objective of selling those assets for a profit at a later date.

Arguably every investor is in some way a speculator. Every investor takes on risk to varying degrees in order to make a profit. This includes investors which purport to be buy-and-hold investors. With few exceptions I will touch on later, buy-and-hold investors are simply speculators in denial who theoretically operate on a much longer time-frame.

A buy-and-holder will slowly purchase the same, or similar assets throughout their working lives and then slowly sell those assets--hopefully for a substantial profit--when they are retired. I say theoretically because countless studies show there are few true buy-and-hold investors. When markets collapse, buy-and-hold investors sell in the panic with everyone else. However, nine years into a bull market cycle selling yourself as a buy-and-hold investor is easy and religiously gratifying.

I embrace speculation and I don't believe in buy-and-hold. Things happen in markets which should make every investor think very hard about their investment strategy. The perfect modern example is Japan where their stock market valuation is still just over 50% of the peak value in 1989--nearly three decades later. This issue isn't exclusive to Japanese stocks though; throughout the ages massive shocks have occurred in assets ranging from government debt to productive land to currency.

No asset is truly safe to hold by any individual investor.

Understanding Speculation

Broadly speaking the value of real, productive assets tends to increase over very long periods of time. This includes things like productive farmland, productive timberland, and other assets which generate some form of generated return.

Tangible, non-productive assets tend to hold their real value absent spoilage. This includes gold and silver, quality furniture, or the structure of a well-built, durable building.

However, over shorter time periods these observations do not hold true at all. Sometimes, such as today when ample credit is available, farmland values get very, very expensive relative to their historical value. Other times, as in the 1930s during the Great Depression, farmland could be bought very cheaply as farmers across North America were going broke. That said, despite the gains in crop production and general decline in food prices, the financial return a farmer could generate from their land has been very similar over the ages.

This same logic doesn't apply to other businesses. Successful businesses can earn substantial profits for their shareholders, but they all eventually fail. The ones that gain effective monopolies can last longer than businesses who do not, but competition means all businesses are eventually extinguished. While buying and holding good farmland or timberland forever could be logically plausible, if not a nerve-wracking investment, holding businesses is ridiculous.

Speculation, or at least the embrace of speculation as many perceive it today, is a great way to profit from the price movements in assets over shorter and medium time frames. It's not as much a bet on the asset itself as it is a bet on the prevailing human psychology which is attempting to price that asset at any given time. Speculation is truly a bet on the collective human emotions involved in the market for that asset.

Playing Both Sides of the Market

Since price of any asset can increase or decrease over the shorter-term, it's important to embrace being "long" or "short" the market as a speculator.

There are many ways to speculate in the market and it seems the list of instruments is growing all the time. The standard method is to simply buy an asset directly or indirectly. An example of a direct holding is buying an individual stock, treasury bond, or currency, while indirect holdings can be through ETFs or mutual funds. However, the derivatives market shouldn't be ignored by more advanced speculators. This includes everything from futures to CFDs to options.

Just like buy-and-hold, being a speculator is risky. You can lose all your money, but you can also make a lot of money. Risk control and understanding your asset is of absolute importance! Limit the size of your positions, maintain stop-loss orders on every position to a low level of loss as a percentage of equity, and spread your bets across numerous assets.

To profit from both sides of the market, you must use a system. Trading on gut feelings or fundamentals is not reliable and is likely to result in very poor returns. Betting on price changes means you should use movements in price only to trigger your bets. Moving averages and breakouts are great tools to help you identify price trends. Buy the upside when the trend is up, sell the downside when the trend is down.

Betting on the Upside

It is generally quite easy to buy, or take a "long" position on any major asset (productive or non-productive). You can buy individual stocks, index funds, call options, futures, bonds, and currencies in any brokerage account. The cost is very low, typically a small commission fee plus interest costs if you borrowed any money to execute that asset purchase. Even the interest costs are very low with the better brokerages.

As discussed before, productive assets collectively have a long-term uptrend in real valuation. This is because businesses (as a whole) generate profits, farms produce food, forests produce timber, and dwellings generate rents. As long as the assets remain productive, this won't change. This is the logic behind buy-and-hold investing.

Non-productive assets will also increase in value, but increases are generally limited to inflation and the price of alternatives. There are countless shorter-term impacts which generally revolve around supply capability and product demand.

Betting on the Downside

Taking a "short" position against a productive asset can be much more difficult and risky. It's important to understand how betting against an asset works and what instruments you should choose to bet on price declines. Price volatility tends to increase when prices fall. This means a large price decline can be followed by a sudden, aggressive price increase (called a bear rally).

To short individual stocks or standard ETFs in a traditional manner, you must borrow the security from someone who owns it and pay them an interest fee and the cost of dividends for that privilege. Someone shorting stocks can easily be forced to close their short position at a loss when bear rallies occur. Even experienced players can very easily lose money this way.

It's generally better to bet against productive assets with more advanced instruments such as put options. Longer dated put options can help a speculator with risk-control while providing the potential for outsized returns. The return profile of options are very asymmetric: you can lose 100% of your investment, but you can gain hundreds of percent on your investment.

Futures and CFDs are other great tools to use when betting on price declines. Although the leverage must be controlled (minimum leverage ratios can be astronomically high), the cost of trading on the upside or downside is equal. There is no downside penalty built in these instruments.

You can also use inverse ETFs, but I would stay away from the leveraged ones for the volatility issue. The Canadian market for inverse ETFs is very thin, but there are several good choices on the U.S. stock market.

The least risky method to benefit from a price decline in a certain asset is to sell that asset and hold cash, waiting to purchase it at some later date for a cheaper price. Systematic switching from holding productive assets to holding cash can be very profitable with minimal costs. Dual Momentum is a great example of an asset to cash system.

Summary

All investors are speculators because they take risks in anticipation of generating a positive return on their capital. If you want to avoid the large medium-term drawdowns that occur in asset prices, you should embrace the idea of being a true speculator. This means betting both on price increases and price declines.

Our modern financial markets are huge and there is no real limit to speculation choices. Nearly anyone with some extra money can buy or sell anything from stocks to treasury bills, from gold to zinc, from oats to oil, from Chinese yuan to South African rand. You can't possible have a good understanding of fundamentals in such a wide variety of assets, so you must speculate using a price-driven system.

It's easiest to speculate on the "long" side of productive assets. This means betting that assets like businesses (as a collective), farmland, or timberland will increase in value over time while providing positive income during the holding period. Buying non-productive assets can also be very profitable during rising price trends.

Betting on price declines requires special care and attention, so you should consider all your choices across various financial instruments. Depending on the underlying asset you are betting against, the best way to profit could be simply selling the asset and holding cash, buying inverse ETFs, buying long dated put options, selling futures contracts, selling CFDs, or selling currencies.

Always use careful risk control in your account to limit losses on any one asset and your account as a whole. This includes stop-losses on position entries, diversification across non-correlated assets, and careful position sizing.

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Tax Time: Are You Getting a Big Refund?

It's that time of year again... tax time in Canada. This year every Canadian must file their 2017 taxes and pay any amounts owing by April 30, 2018. That's a little more than two weeks from today.

As most of you know, taxes in Canada are quite complicated. I always do my own tax returns using Genutax. There are other great software programs out there as well: Simpletax, Turbotax, and Studiotax for example. Doing your own taxes is a great way to understand how much tax you are paying and what you can do to reduce that amount as much as possible in the future. Trust me, the nice lady at the mall kiosk doesn't care.

Our tax system is a myriad of credits and deductions at both the federal and provincial levels. Child care, RRSP contributions, medical expenses, education, charitable contributions, union dues, interest costs, pension adjustments, kids fitness, arts, and whatever your government decides is good for you at that moment in time.

After you plunk all those numbers in your tax return, you find out if you get a refund from the government or if you owe them more money than what you already paid. What is the best outcome?

Getting a Nice Refund

Most people are very happy when they get a refund cheque sometime in April or May. However nice this little bonus might seem, it is NOT the ideal outcome. Do not confuse a refund with some form of extra income. Extra income is something like the Canada Child Benefit or Old Age Security--money from the government that is not really paid by you but which you receive on a regular basis because you meet certain criteria. A refund is getting your money back because you paid too much to begin with.

Put it this way... you go to the store and buy a pair of pants that cost $100 but was marked 20% off. The clerk made an error that you didn't immediately notice and charged you $100 plus tax. You paid full amount, stuffed the pants into your backpack, hopped on your bike and were halfway home when the thought crossed your mind that you paid too much. You check your receipt and sure enough the discount wasn't calculated, so you bike back to the store and get your $20 back.

Did you earn back that $20 from the store? Absolutely not! You made the purchase expecting the discount amount so you are simply getting a refund because the store collected to much money from you in the first place. It's actually inconvenient because you wasted your time, effort, and dignity by going back to the store and grubbing for that $20 you never should have paid in the first place. This simple mistake makes you obliged to the store rather than the store being grateful for your business.

Tax refunds work the same way. Your employer follows some standardized criteria to deduct money for taxes from each paycheque all year long. It's not tailored to your personal situation and is actually designed to make sure you pay more than you need to.

By giving the illusion of having the government owe you rather than you owing the government, you are now at their beck and call. You will file your tax return on time, you will appreciate anything they give you back, and if they dispute something you've done on your return, they hold back money which is rightfully yours until you prove yourself innocent.

The government wants to give you a refund because it's insurance. Also, it ensures they get paid first and it gives them an interest free loan that grows all year. If five million Canadians get an average refund of $500 every April, that's an accumulated free loan of $2.5B every year.

If you get a tax refund every year, especially a big one, you are doing something wrong. You should first ask your employer for a TD1 form. This form allows you to direct your employee to adjust your tax deductions lower for things like the age amount, caregiver amounts, education amounts, and disability amounts.

Next you need to look at the T1213 Form. The T1213 must be sent to the CRA after you complete because they must provide approval before your employer can reduce tax deductions. The T1213 allows you to deduct things like RRSP contributions, child care expenses, family support payments, investment loan interest expenses, and many other items.

By completing a TD1 and T1213 accurately, you should be able to drastically reduce the amount of your tax deductions each paycheque and the size of the tax refund every April. The only downside is this must be done every year, however the pay-off is worth the postage stamp.

Pay a Little More Tax

This might sound a little counter-intuitive, but if you are doing your tax preparation correctly every year you should actually be paying the CRA a small amount after your tax returns are done each April. I'm not talking thousands of dollars that you can only pay with a line of credit because you don't have the cash on hand, but a moderate amount that you can afford is perfectly fine.

While your co-workers brag about the size of their refund, calmly cut the government a cheque and understand you are better off for it. Not unlike using a credit card to collect points or cash back, it's alright to be in debt to the government as long as you pay them back when you are supposed to.

Enjoy filing your taxes in the next few weeks and if you are getting a refund, check out the TD1 and T1213 to make sure it doesn't happen again! Of course, if your refund is due to RRSP contributions make sure you put that money into your investment account because you will owe taxes on RRSP withdrawals down the road. If your refund is not because of RRSP contributions, still invest it and put that money to work for your future self!

Comments & Questions

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Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.