Paul Krugman of the New York Times recently joined the bandwagon of politicians, economists, and financial journalists calling for an incremental tax on every financial transaction. The initial proposals suggest a levy of .25% of the value of the transaction. The theory behind such a scheme is that by making the actual transaction be orders of magnitude more expensive, it would have the purpose of deterring short term trading by "speculators," which has been referred to as "socially useless" by Britain's top financial regulator.
The false premise behind this tax and the continuing firestorm around high-frequency trading is that there is a difference between "investing" and "speculating." The notion is that "investing" in stocks or bonds are a good thing for America while "speculating" in the same instruments is evil. All investing, however, is a form of speculation; the goals are exactly the same - to yield a positive return on the capital deployed - nothing less, nothing more.
Whether that positive return comes from holding shares of Apple for 3 years or 3 seconds, the thought process, results and social benefit are identical. For example, a traditional mutual fund manager spends months researching Apple and its prospects for growth. After careful analysis, he determines that the company is likely to be worth significantly more 3 years into the future. Based on that conclusion, the manager makes a bet on the future price of Apple stock by buying shares and holding them for a 3 year period. Contrast that with an independent, high frequency trading firm that was created to take advantages of short term price movements. This firm also has investors and its employees have worked diligently for years designing software and algorithms to take advantage of short term price fluctuations. Instead of making a single 3 year bet on the future price of Apple, it makes numerous smaller wagers, each averaging only 3 seconds, every single day.
How are these two scenarios not the same? In neither instance did Apple the company receive any financial benefit or suffer any financial harm, nor did the actions of either benefit or harm the overall American economy. Investors in each firm made profits, which looked precisely the same when they cleared their checking account. Consequently, those investors are equally capable of buying a new home, paying for a child's college education or buying a new car. In fact, the high frequency investor likely paid far more in taxes than the long term speculator. Current US tax code levies a 15% rate on securities held over 12 months. Short term profits, though, are treated as traditional income by tax laws so the high-frequency trader can pay more than double the taxes of long term speculators, depending upon their tax brackets.
Far from being "socially useless," the high-frequency trading firm's mere existence provides many economic benefits. A typical high-frequency trading business purchases millions of dollars of computer and network hardware, most often from companies such as Hewlett Packard, Dell, Intel and Cisco. It leases out bandwidth and data center space from the telecommunications operators. Its employees and those of its primary suppliers are likely to be highly technical and well compensated. These are all examples of the type of jobs we, as a country, ought to be striving to have more of, not less.
The only true difference between an investor and a speculator is one of naïveté. An investor is a person who does not yet realize the risks of his speculations. Americans must more clearly acknowledge that no investment is without risk. We need to also realize any investment in stocks, bonds, infrastructure or even education is merely a speculation that the future value will be greater than the present cost. As soon as we understand this simple fact we can focus less on flawed tax proposals and more on making intelligent speculations, er, investments.
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