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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When Dividend Investing Fails

A few weeks ago I was busy re-formatting the blog and going back through my old blog posts. It's always fun to take a peek back in time and see what I discussed. One post that caught my eye was my Dividend Investing post back in May 2017. It interested me because I'm not a big fan of dividend investing and the results were quite revealing: don't focus on dividends, especially when they no longer offer a value proposition.

Dividend investing is huge in Canada! Just about every bigger financial blog written by Canadians for Canadians has a overwhelming positive view on dividend-focused investment strategies. Fortunately some are slowly turning towards index investing and other strategies, but that allure of cash payments dropping into your account on a monthly or quarterly basis is just too much for many to resist.

Maybe dividend investing made a lot of sense at one point in time. Mutual funds in Canada used to the chief comparison for the dividend crowd and we know Canadian mutual funds are generally a rip-off. Then there's the whole value argument that once was linked to dividend investing.

Further, dividends get very nice tax treatment, especially for lower-income Canadians such as retirees. Back when the capital gains inclusion rate was higher than it currently is, dividends were a clear winner in non-registered accounts. In RRSP accounts there are some tax advantages for investing in U.S. dividend stocks.

Dividend Investing Isn't What It Seems

The strategy behind dividend investing (when done correctly, of course) was actually not a terrible one at first glance. However, contrary to what you might have been led to believe by the dividend crowd, it was not good because of the dividend income stream.

Dividend investing was actually a pseudo-value strategy with a buy-and-hold tendency because of the focus on income rather than investment price. Companies that paid investors a healthy portion of their profits and increased their dividends over time were historically cheaper than the broad market. It's never a bad strategy to invest in a basket of companies that are cheaper than the overall market, be that on a price-to-book, price-to-earnings, or price-to-sales basis.

Meb Faber recently completed a white paper that further demonstrates what I am talking about. He also shows investors are better off using proper value metrics and staying away from attraction to those dividends.

It's important to always understand what you are really investing in and why your strategy gives you an edge in the markets. If you were investing in a strategy that turns out to actually be a value-driven strategy, it no longer makes sense to invest in that strategy if the valuations of those companies have gone totally crazy while the growth prospects remain muted.

There are so many viable investment strategies out there, it hardly makes sense to chase any one strategy with blinders on. Dividend investing, like any active individual stock strategy, takes a fair amount of work. When the prospect of outsized returns has disappeared--even if it's just temporary--why not focus your investing on indexing instead and save yourself the time and trouble of analyzing individual stocks. If you still want to put in the work, then invest in something more sound on a risk-reward basis like trend following.

Dividend Investing vs. Trend Following

The biggest problem with Canadian-listed dividend companies in general is that they got ridiculously expensive. I would say the blame for this lies squarely on massive government intervention in the financial markets, particularly since 2009. People used to be able to dump a big chunk of their portfolio in government bonds and earn 5% interest income; those days seem to be gone for now.

The only place left where you can get decent income is dividend stocks and REITs. Since 2009, the rush into these categories has been phenomenal. This wave of money made prices ridiculously high given the real growth prospects of these old-guard industries. That underlying value premium which historically benefited investing in dividend stocks is gone.

In my May post, I talked about the insane valuations of some of these Canadian dividend favourites. I specifically mentioned Loblaws (L.TO), Emera (EMA.TO), and Enbridge (ENB.TO) as being very expensive. Turns out I wasn't wrong in my belief that these companies had poor prospects going forward. If you had invested in these companies, you would be down around 15% since last May.

I am not a predictor and I had no clue that the prices of these stocks would begin to collapse, but at the appropriate time the trend lines would have quickly told you something wasn't right and that it was time to get out.

Let's have a look at their 1 year charts:

Source: Yahoo Finance

Source: Yahoo Finance

Source: Yahoo Finance

May 2017 was the clear peak price for both Enbridge and Loblaws. Emera ran up a bit more until December before turning negative. If you follow the long moving average line (purple one), you can see the price trends clearly flattening out and turning down. Selling when the price moved below the moving average would have significantly reduced your losses.

These are some great examples of why trend following works and why I prefer it to dividend investing. The system makes sense and doesn't depend on any fundamental evaluation or crowd promotion. Everything is baked into that price and I'll stay in the trend until it bends.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

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