The Theory of Stock Exchange Speculation

by Arthur Crump

The number of people who play publicly at games of chance is very small compared with the number of people who gamble in mercantile transactions. And whereas the former are diminishing, partly from compulsion, as in the case of Germany of late, and partly through the more enlightened state of the human understanding as regards the immorality of this kind of amusement, the latter appear to multiply in proportion to the general increase of wealth, the ever enlarging fields in which public securities are dealt in and commercial transactions are negotiated, and also in proportion to the facilities afforded for speculation generally. The latter part of this sentence should, however, be qualified by the remark that the spread of wealth enables younger and less experienced persons to engage in speculation in a larger proportion as compared with the whole community than formerly. The difficulty of living and the ambition not to fall below the standard maintained by the well-to-do, tempt numbers of young men to endeavour to increase their income by speculation. And moreover as regards Stock Exchange speculation it is unfortunately much against the interest of the stock broker to make public the failure of his clients, hence it is seldom that the wholesome warning of publicity deters others from entering the arena.

Outsiders entering upon speculation with professional dealers in the Stock markets make two mistakes on the threshold. Firstly, they commence upon unequal terms, the effects of which adventitious favourable influences have never more than compensated for, in the long run. Secondly, supposing the terms were permitted to be equal, the outsiders’ stakes would be too large a proportion of their means. The losses incurred by speculators as a body have always been upon such a scale as to dispose of the theory advocated by some persons that the mere charges of commission, contangoes, and the “turn” are the only obstacles to success.

Now, if the playing of public games of hazard are on the decline from the interference of the State on moral grounds, the question arises: are there any considerations applying to Stock Exchange gambling, which, as a game, raises it above other games of chance, and entitles it to special privileges? Does the outside haphazard speculator stand a better chance as against the Stock Exchange, than a player at Rouge et noir against the bank? The answer must be No. Exactly the same considerations apply to commercial speculations as to other games of chance in which no absolute certainty exists. Mathematicians lay it down as a law, that if any possible event which cannot frequently occur in a game of chance, but which is, nevertheless, a part of the nature of the game, if a bet or stake be made upon the recurrence of that event in a proportion to some large gain which it is agreed that event shall secure, then prudence demands that the game shall be often played; and if this be impossible it shall not be played at all. Here we come to the crux of the whole question of Stock Exchange speculation. Unless a speculator, handicapped as we shall show he is to start with, has enough means to enable him to hold out for the arrival of the event, the occurrence of which is absolutely necessary to his keeping above water, he should not speculate at all.[7]

What is the one event constituting the benefit for which the speculator operates? it will be asked. The answer is, the greatest fluctuation in the direction favorable to him which may be caused by any one of the many influences that may spring into action at any time. This is part of the mystery which allures people on. If you tell persons who are throwing a die that the six will turn up once in six times in the long run, they can form some estimate of their chance of winning. But until a Stock Exchange speculator has been roughly undeceived, his understanding gets entangled so that what he sees clearly only at first, is what is in his favour, because his first interest is to discover that. What is against him, he disregards until he has discovered it has undermined him, and all goes together.

In cases where the public play against a bank, it is so managed that the bank has a better chance than the players. It is so managed that a considerable succession of losses can be sustained against the good luck of any comer. One side always secures to itself the benefits of the long run. The haphazard speculator stands at the same disadvantage as the player against the bank. His position is always relatively inferior. When the balance is nothing, as worked out by the following rule as stated by De Morgan, then the play is equal:—“Multiply each gain or loss by the probability of the event on which it depends; compare the total result of the gains with that of the losses: the balance is the average required, and is known by the name of the mathematical expectation.”

It must stand to reason that an outside speculator plays upon unequal terms, otherwise it could not be worth the while of the other side to engage him. As well might we expect a man to set up a shop and sell his goods at a loss. Then we come a step farther, and ask if it be any use for a Stock Exchange speculator to operate if the terms be equal? If such numbers of persons find themselves induced, by the estimate they are enabled to form of the chances in their favor, to play on terms more favourable to their antagonists than to themselves, their prospects would seem to be much improved if the terms were made equal. Although the position of the speculator be improved to the extent of the terms being equal, it is absolutely indispensable that the operations be kept open for a considerable time[8] in order to secure the mathematical expectation which can have no existence except through continuity. With the play in favour of the gambler, he stands no chance even of holding his own, unless he makes sure of being able to continue over such a number of trials, or during such a period of time, as will give him the benefit of an average of the ups as well as the downs of fortune.

As at cards so at Stock Exchange speculation, there must be two kinds of luck, ill-luck and good-luck, as the changes of fortune which are worth while taking account of. A man speculates, gets his turn of good luck and pockets his gain, treating the money as if it were ore from a mine, or something added to the realized wealth of the world, a pure plus as compared with a plus leaving a minus. For every profit made by a speculator, and for every realized profit made by a bona fide investor, there must be a corresponding loss. The man who in his turn is a winner, must also in his turn be a loser, and what he was plus when he won, he must be minus when he loses.

If the manager of gaming-tables secures to himself a mathematical advantage only sufficient to cover the expenses, he will infallibly be ruined at last. It may be in one year or in five, or ten, but ruined he must be. But he provides adequately against this, and in the long run those who play with him must be ruined. So it is with Stock Exchange speculators.

It is the character of negative events to lay less firmly hold of the mind than positive ones. The minds of Stock Exchange speculators are like other people’s minds. A speculator will often attribute a certain movement in prices to an influence which happened to be exercised at a particular moment, and he contents himself with the apparent connection of the two, and looks no farther. On another occasion, when operating in the same way, immediately upon the recurrence of the same influence he is bewildered to find prices move in an opposite direction. This comes from being satisfied with any solution which lies on the surface, and chances to catch the eye. It used to be supposed that comets were the cause of hot weather, and the theory was considered to be well founded, because more comets were seen during the summer months than at other seasons of the year. Hot and cloudless weather is most favourable for seeing comets, but they are no more productive of hot weather than is hot weather of them. This circumstance being fixed upon by one class of theorisers, shows how an event which is positive lays hold of the mind of any person who may be interested in certain effects and is in search of the causes. It is of great importance, in endeavouring to connect certain effects with specific causes, to mark carefully two distinct things, first, the occurrence of an event, and, secondly, our observation of it. Many entirely wrong deductions as to the causes of fluctuations in the value of money, and in the prices of Stock Exchange securities, are made from negligence in this respect.

As every rule has its exception, so in speculation are there a few professional experts who succeed at it as a business. What is contained in these pages is not for the expert, who is well able to take care of himself, but for the ordinary haphazard operator. The professional speculator, who has the right sort of head, sufficient capital, patience, perseverance, coolness, and a business-like aptitude for laying down the elaborate machinery that is necessary for mercantile success, may succeed. In the following chapters it is our intention always to make this reservation, and in speaking of the speculator, who must always lose in the long run, we refer to the ordinary run of men, whom we will designate as haphazard speculators.