A Random Walk Down Wall Street

by Burton G. Malkiel

The firm-foundation theory argues that each investment instrument, be it a common stock or a piece of real estate, has a firm anchor of something called intrinsic value, which can be determined by careful analysis of present conditions and future prospects. When market prices fall below (rise above) this firm foundation of intrinsic value, a buying (selling) opportunity arises, because this fluctuation will eventually be corrected—or so the theory goes. Investing then becomes a dull but straightforward matter of comparing something’s actual price with its firm foundation of value.

In this kind of world, a sucker is born every minute—and he exists to buy your investments at a higher price than you paid for them. Any price will do as long as others may be willing to pay more. There is no reason, only mass psychology. All the smart investor has to do is to beat the gun—get in at the very beginning.

He was charged an amount called the option premium, which might run 15 to 20 percent of the current market price. An option on a tulip bulb currently worth 100 guilders, for example, would cost the buyer only about 20 guilders. If the price moved up to 200 guilders, the option holder would exercise his right; he would buy at 100 and simultaneously sell at the then current price of 200. He then had a profit of 80 guilders (the 100 guilders appreciation less the 20 guilders he paid for the option).

Robert Shiller, in his book Irrational Exuberance, describes bubbles in terms of “positive feedback loops.” A bubble starts when any group of stocks, in this case those associated with the excitement of the Internet, begin to rise. The updraft encourages more people to buy the stocks, which causes more TV and print coverage, which causes even more people to buy, which creates big profits for early Internet stockholders. The successful investors tell you at cocktail parties how easy it is to get rich, which causes the stocks to rise further, which pulls in larger and larger groups of investors. But the whole mechanism is a kind of Ponzi scheme where more and more credulous investors must be found to buy the stock from the earlier investors. Eventually, one runs out of greater fools.

The consistent losers in the market, from my personal experience, are those who are unable to resist being swept up in some kind of tulip-bulb craze. It is not hard, really, to make money in the market. As we shall see later, an investor who simply buys and holds a broad-based portfolio of stocks can make reasonably generous long-run returns. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges.

When the bubble bursts, the feedback loop goes into reverse. Prices decline and individuals find not only that their wealth has declined but that in many cases their mortgage indebtedness exceeds the value of their houses. Loans then go sour, and consumers reduce their spending. Overly leveraged financial institutions begin a deleveraging process. The attendant tightening of credit weakens economic activity further, and the outcome of the negative feedback loop is a severe recession. Credit boom bubbles are the ones that pose the greatest danger to real economic activity.