The Identification and Measurement of Speculative Risk

Recent falls in stock markets have once again exposed investors in superannuation and managed funds to negative rates of return. A common, and possibly self-interested, response from the managed funds industry is that such declines can only be anticipated in hindsight. While acknowledging that this is sometimes the case, stock market levels such as those reached in Australia in 1987, the UK in 1999 and the USA in 2000 can be shown to have involved a high degree of speculative risk - the chance that purchases at such levels were extremely unlikely to provide a reasonable return for long-term investors. Poor long-term performance from such levels could have been anticipated, even though the timing of any sharp decline could not. The thesis of this paper is that speculation can be identified using two quite different approaches to analysis. Given a definition that is relevant to investors with long-term objectives, speculative risk can then be measured. If speculation can be identified and speculative risk can be measured, then it can be avoided in investment decisions and taken into account when valuing actuarial liabilities. This is particularly relevant for defined benefit funds as demonstrated recently in UK pension schemes. Keywords: Speculative Risk, Discount Rates, Implicit Market Returns