The Theory of Stock Exchange Speculation

by Arthur Crump

“If we hope for things of which we have not thoroughly considered the value, our disappointment will be greater than our pleasure in the fruition of them,” wrote Addison.

The most brilliant good fortune which may result from the operations of a speculator generally fall below his anticipations, when the operations are reduced to figures. It appears that the imagination gets, as it were, diseased by feeding on the contemplation of very rapid gains; and that whatever may be the reality of a hypothetical gain, the mind gets bewildered and fails to estimate as an element of loss, the surrounding husks in which the fruit is enclosed. One forgets that every tangible advantage, in whatever form obtained in this life, has to be got out of a shell. What, then, must be the speculator’s feelings when the balance is on the wrong side of the account?

It has been suggested that the abolition of “time-bargains” would materially, if not quite, prevent much of the mischief that results from speculation; but it is no more possible entirely to do away with the custom of “time-bargains” than it is to abolish credit in other kinds of business. It may be readily conceded that a very large number of those who are ruined or greatly injured by Stock Exchange speculation, would never operate at all if they were called upon even to make a deposit before the purchase was effected. But when it is considered that to abolish “time-bargains” would be to ruin at once half the brokers in existence, the difficulty of effecting what from one point of view would be a most salutary change of custom, will be understood. In our day money is so closely employed that a fortnight is not too long to get the funds together, when, for some good reason or other, a change of investment has been determined on. It is often that such a transfer gives rise to a course of speculation that ends in disaster. A purchase effected for the account[2] with the view of changing from one stock to another leaves at the end of the fortnight, we will suppose, a handsome profit. The buyer of the stock takes it, and postpones the intended change of investment, thinking he shall get rich sooner by such an operation as that, than by simply transferring his money to another security that promised a better yield per cent. He has another try, expecting the same good fortune. In the end he loses as usual on balance, which he would not probably have done if he had bought and sold for money, finishing the operation on the same day. This is what often causes loss to people who can afford to lose, if they stop soon enough. The great mischief is done by the facilities afforded by “time-bargains” to operators who have a little money, just sufficient to enable them to keep afloat as speculators in fair weather. The first serious disturbance that violently agitates prices sweeps them away in a shoal.

The question which a sensible speculator will ask himself before he begins to operate is, What are the risks incurred of losing his all at one stroke? De Morgan, in his book on probabilities, says in Chapter V., on the risks of loss or gain, “A man should not hazard his all on any terms; but in ventures the loss of one of which would not be felt, we may suppose the venturer able to make a large number of the same kind; in which case the common notions of mankind reinforced by the results of theory, tell us that the sum risked must be only such a proportion of the possible gain as the mathematical probability of gaining it is of unity. For instance: suppose I am to receive a shilling if a die, yet to be thrown, give an ace; in the long run, an ace will occur one time out of six, or I shall lose five times for every time which I gain. I must, therefore, make one gain compensate the outlay of six ventures, or one-sixth of a shilling is what I may give for the prospect, one time with another. But one-sixth is the probability of throwing the ace. Principle—Multiply the sum to be gained by the fraction which expresses the chance of gaining it, and the result is the greatest sum which should be given for the chance.”[3] “A man should not hazard his all on any terms.” Does a man who enters upon a career of speculation take the trouble to consider at starting whether or not his first operation places him in a position in which he hazards his all? There is not probably one speculator in a hundred who ever thinks of it at all. We will suppose a man to be worth £200 in cash as his all, applicable to the payment; of losses. It may safely be stated that numbers of speculators open accounts with a less sum, in fact a considerable proportion of speculative operations are entered upon in reality without any funds at all; misfortunes in other vocations being frequently followed by gambling in the Stock markets. A speculator with £200 to pay losses with is in this position if he buys, for instance, for the rise £5,000 of any English railway stock; a fall of 5 per cent., which even in two or three days is nothing very extraordinary, carries him £50 “under water.” What can he reckon upon on the other side, by keeping the account open, that is a mathematical certainty like the occurrence of an ace one time out of six in the long run in throwing the die? If he be exposed to such a loss at any moment as that mentioned, the risk is an absurd one to run if there is not at least an equal chance of a similar rise, and several times £250 in reserve. But all experienced in Stock Exchange fluctuations know that upward movements are, as a rule, gradual, a rise of 1 per cent. being considered as a profit which a speculator should without hesitation take, while a fall all round in a market of two or three per cent. in a day is of more common occurrence.[4] It may here, perhaps, be retorted that if a fall of 5 per cent. is nothing very extraordinary to happen in a few days, while a rise is, as a rule, gradual, why not speculate for the fall? The answer is, that the public are very seldom indeed bears. It goes against the grain. Speculation with the public, as a body, is a fair weather game. When the most potent influences are affecting the Stock markets downwards, ordinary people hold aloof. We shall go more into detail with reference to this peculiarity farther on. That it is so is a fact, and it is easily accounted for. When you are dealing with a die, a hexagonal body, you know that it must fall on one of its six sides, and that each side to a certainty will have its turn, and therefore a mathematician is able, from there being a limitation set to the risk incurred, to estimate to a fraction what amount a thrower of the die can afford to venture, five times out of six, on the chances of the ace turning up, so that in the long run he will not lose. A game of die-throwing for money, conducted by one of two players upon principles based upon the doctrine of probabilities, and upon conditions to give him a certain profit, can only be continued for a short time, as the absurdity of it becomes speedily evident to the other player, and play ends. Those with whom outside speculators deal in the Stock markets get all the profit also in the long run, much upon the same system that professional bettors on horse-racing always win in the long run by backing the field. In the die-throwing gambling there is no mystery, at least very little for the ordinary understanding. A person of average intelligence who is quite unable to comprehend that it is a mathematical certainty that a die will show the ace upwards, in the long run, one time in six, can be got by simple observations to see that in a great number of throws the ace will have appeared about as often as once in six throws. The fact of his losing his money through betting that it would not be so would, in any case, bring the truth home to him. The case, however, of speculation in the Stock markets is very different. Although so large a proportion of speculators speedily lose their money, a large proportion of them also, when quitting the arena through want of capital to go on with, seem to entertain a strong conviction that money is to be made at it. There is very frequently an impression left that if this and that, and the other, had been done instead of what was done, the result would have been otherwise. They regret that their purse was not longer that they might try again, feeling sure that with such a rich experience they would avoid the mistakes that had landed them losers. The Stock Exchange speculator has an innumerable number of influences arrayed against him, at least one-half of which he never sees at all until, like the sunken snag, which sinks the steamer without any warning, one or other of them wrecks his fortunes before he is aware of his danger.

A speculative operator has a very dangerous basis upon which to lay the foundations of the argument by which he endeavours to justify himself, and it is this. He says to himself: “there are only two ways for a price to move—up and down.” At first sight the chances seem to be as much in his favour as against, and he thinks the failure of others to make a profit must have been the result of mistakes made by them, which he will avoid. But does it occur to such an one that if there were any easy and certain method of making money by speculating in stocks everybody who had a little capital would at once commence to speculate? Speculation in the Stock markets has almost irresistible attractions as a mere amusement, quite apart from its being a kind of occupation which is the most luxurious and exciting mode of making money. It must be evident therefore from the comparatively few persons who habitually speculate, that large numbers are simply driven away from the markets through a conviction that such a vocation must end in disaster. The dangers of Stock Exchange speculation are made apparent when, as a species of gambling, it is compared with the games of chance, whose evil effects upon the community have been at last recognised by the abolition of the tables at Hombourg, Ems, Baden Baden, &c. The conductors of the Bank at the Palais Royal were fully alive to the necessity of limiting the stakes, and also as regards the number of persons with whom they would play at once. Governments are stepping in by degrees to suppress gaming houses, and it would have been more to the credit of Germany if the tables at the above-mentioned places had been done away with while the effects of the golden stream from beyond the Rhine were as yet unfelt by the comparatively poor exchequer at Berlin. The interference of a government is shown again by our own legislature having declared that A should not insure the life of B, unless it can be shown that A has some pecuniary interest in B’s continuing to live. The law, however, is for the most part evaded. Such systems are therefore looked upon as bad; but because it is difficult for governments to define in Stock Exchange gambling where bona fide business ends and the gambling begins, the most injurious of all games of chance is played year after year upon an increasing scale. At the first beginning of prosperity with a comparatively poor community, gambling springs up in these times in stocks and shares. As a result of such operations Vienna went half mad in the first half of 1873, which was followed shortly after by a financial crash and the suicides of certain bankers at Posen. Older communities, which have passed through the only crucible which in this life teaches people that if money is to be made rapidly the process must be attended with a proportionately large risk, are observed, as time goes on, to be less exposed to the headlong financial panics such as that in which the speculation at Vienna lately culminated. Commercial revulsions of one sort or another, and of greater or less violence, will probably occur during all time at intervals, wherever commerce is carried on, but the gradual fashioning of laws with the view to confine the injurious effects of over-speculation and over-trading within limited areas, as for instance the limited liability acts, will more and more render it possible to stand between the dupe and the financial sharper, and also to observe the gathering together for harm of the dangerous influences, so that they may be provided against in time, or checked at an early stage of the disease. Among the operators at younger commercial centres there is a more feverish desire to gain, but the efforts to satisfy it are not kept in check in the same degree as in places where memories of disaster cluster in traditions among the people, and inspire the growth of prudence, almost as if it were an instinct.

Farther on we shall call attention to the way in which an outside speculator on the Stock markets is handicapped with turns, commissions, and contangoes.[5]

Very few persons, if any, will be found to dispute the statement that speculation on the Stock Exchange is gambling. The highest mathematical authorities maintain that there are but two conditions under which gambling can be prudently followed as an amusement, viz.: small stakes, and equal play.

The ordinary gambler in the Stock market is no better off, as regards his chance of winning, than a player against a bank, which can only make certain of winning against all comers in the long run by the protection of a mathematical advantage. In the case of a bank established as a gaming-house the initial condition of existence has always been in the long run either bankruptcy to itself, or ruin to the individual players. As the banks have always flourished, the players, in the long run, must always have been losers.

A gaming-bank is an institution with limited means offering to play all who enter; or, in other words, it is limited means against unlimited means.

The Stock Exchange occupies a parallel position to that of the bank, and the operators[6] in the markets are protected in such a way that the outside player at speculation must in the long run lose, or no one would be found to take up his challenge. It must be obvious that supposing an outside speculator had any advantage when speculation in stocks and shares were first practised, and through such an inequality of terms he was on the average the gainer, experience would soon show the necessity of rectifying such a state of things, and what would be tantamount to the mathematical advantage secured to the gaming-bank would be speedily arrayed against him.