DEFINITION of 'Speculation'

The act of trading in an asset, or conducting a financial transaction, that has a significant risk of losing most or all of the initial outlay, in expectation of a substantial gain. With speculation, the risk of loss is more than offset by the possibility of a huge gain; otherwise, there would be very little motivation to speculate. While it is often confused with gambling, the key difference is that speculation is generally tantamount to taking a calculated risk and is not dependent on pure chance, whereas gambling depends on totally random outcomes or chance.


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BREAKING DOWN 'Speculation'

It may sometimes be difficult to distinguish between speculation and investment, and whether an activity qualifies as speculative or investing depends on a number of factors, including the nature of the asset, the expected duration of the holding period, and the amount of leverage.

For example, while acquiring an additional property (in addition to one's principal residence) with the intention of renting it out would qualify as a bona fide investing activity, buying half a dozen condominiums with minimal down payments for the purpose of "condo-flipping" would undoubtedly be regarded as speculation.

Speculation has its benefits in a free economy. By their willingness to assume the other side of the trade (for a price, of course), speculators provide market liquidity and narrow the bid-ask spread, enabling producers to hedge price risk. Speculative short-selling may also keep rampant bullishness in check and prevent the formation of asset price bubbles.

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