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April 1 - July 8, 2024
A random walk is one in which future steps or directions cannot be predicted on the basis of past history. When the term is applied to the stock market, it means that short-run changes in stock prices are unpredictable.
I view investing as a method of purchasing assets to gain profit in the form of reasonably predictable income (dividends, interest, or rentals) and/or appreciation over the long term.
It is the definition of the time period for the investment return and the predictability of the returns that often distinguish an investment from a speculation. A speculator buys stocks hoping for a short-term gain over the next days or weeks. An investor buys stocks likely to produce a dependable future stream of cash returns and capital gains when measured over years or decades.
I believe investors should not dismiss the possibility that noticeable inflation will characterize the future.
productivity improvements are harder to come by in some service-oriented activities.
It is clear that if we are to cope with even a mild inflation, we must undertake investment strategies that maintain our real purchasing power; otherwise, we are doomed to an ever-decreasing standard of living.
Traditionally, the pros in the investment community have used one of two approaches to asset valuation: the firm-foundation theory or the castle-in-the-air theory.
Toward the end of the twentieth century, a third theory, born in academia and named the new investment technology, became popular on “the Street.”
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.
Discounting basically involves looking at income backwards. Rather than seeing how much money you will have next year (say $1.05 if you put $1 in an investment yielding 5 percent), you look at money expected in the future and see how much less it is worth currently (thus, next year’s $1 is worth today only about 95¢, which could be invested at 5 percent to produce approximately $1 at that time).
He went on to argue that the intrinsic value of a stock was equal to the present (or discounted) value of all its future dividends. Investors were advised to “discount” the value of moneys received later.
The theory stresses that a stock’s value ought to be based on the stream of earnings a firm will be able to distribute in the future in the form of dividends or stock buybacks. It stands to reason that the greater the present dividends and their rate of increase, the greater the value of the stock; thus, differences in growth rates are a major factor in stock valuation.
The point is that the firm-foundation theory relies on some tricky forecasts of the extent and duration of future growth. The foundation of intrinsic value may thus be less dependable than is claimed.
Buffett compiled a legendary investment record, allegedly following the approach of the firm-foundation theory.
It was his opinion that professional investors prefer to devote their energies not to estimating intrinsic values, but rather to analyzing how the crowd of investors is likely to behave in the future and how during periods of optimism they tend to build their hopes into castles in the air. The successful investor tries to beat the gun by estimating what investment situations are most susceptible to public castle-building and then buying before the crowd.
With regard to stocks, Keynes noted that no one knows for sure what will influence future earnings’ prospects and dividend payments. As a result, he said, most people are “largely concerned, not with making superior long-term forecasts (for) an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.” Keynes, in other words, applied psychological principles rather than financial evaluation to the study of the stock market.
It is analogous to entering a newspaper beauty-judging contest in which one must select the six prettiest faces out of a hundred photographs, with the prize going to the person whose selections most nearly conform to those of the group as a whole.
to predict what the average opinion is likely to be about what the average opinion will be,
The Nobel laureate Robert Shiller, in his book Irrational Exuberance, argues that the mania in Internet and high-tech stocks during the late 1990s can be explained only in terms of mass psychology.
Res tantum valet quantum vendi potest. (A thing is worth only what someone else will pay for it.)
The tulip-bulb craze was one of the most spectacular get-rich-quick binges in history.
Many of these flowers succumbed to a nonfatal virus known as mosaic. It was this mosaic that helped to trigger the wild speculation in tulip bulbs. The virus caused the tulip petals to develop contrasting colored stripes or “flames.” The Dutch valued highly these infected bulbs, called bizarres. In a short time, popular taste dictated that the more bizarre a bulb, the greater the cost of owning it.
The instruments that enabled tulip speculators to get the most action for their money were “call options” similar to those popular today in the stock market.
A call option conferred on the holder the right to buy tulip bulbs (call for their delivery) at a fixed price (usually approximating the current market price) during a specified period. He was charged an amount called the option premium, which might run 15 to 20 percent of the current market price.
The South Sea Company, which obligingly filled the need for investment vehicles, had been formed in 1711 to restore faith in the government’s ability to meet its obligations. The company took on a government IOU of almost £10 million. As a reward, it was given a monopoly over all trade to the South Seas. The public believed immense riches were to be made in such trade and regarded the stock with distinct favor.
Just as speculators today search for the next Microsoft, so in England in the early 1700s they looked for the next South Sea Company. Promoters obliged by organizing and bringing to the market a flood of new issues to meet the insatiable craving for investment.
New companies seeking financing during this period were organized for such purposes as the building of ships against pirates; encouraging the breeding of horses in England; trading in human hair; building hospitals for bastard children; extracting silver from lead; extracting sunlight from cucumbers; and even producing a wheel of perpetual motion.
The prize, however, must surely go to the unknown soul who started “A Company for carrying on an undertaking of great advantage, but nobody to know what it is.” The prospectus promised unheard-of rewards. At nine o’clock in the morning, when the subscription books opened, crowds of people from all walks of life practically beat down the door in an effort to subscribe. Within five hours, one thousand investors handed over their money for shares in the company. Not being greedy himself, the promoter promptly closed up shop and set off for the Continent. He was never heard from again.
Not all investors in the bubble companies believed in the feasibility of the schemes to which they subscribed. People were “too sensible” for that. They did be...
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Similarly, the price of Mississippi Company shares fell to a pittance as the public realized that an excess of paper currency creates no real wealth, only inflation.
as Calvin Coolidge said, “The business of America is business.” Businessmen were likened to religious missionaries and almost deified.
Bruce Barton, of the New York advertising agency Batten, Barton, Durstine & Osborn, wrote in The Man Nobody Knows that Jesus was “the first businessman” and that his parables were “the most powerful advertisements of all time.”
Borrowing to buy stocks (buying on margin)
More important, stock-market speculation was central to the culture. John Brooks, in Once in Golconda,* recounted the remarks of a British correspondent newly arrived in New York: “You could talk about Prohibition, or Hemingway, or air conditioning, or music, or horses, but in the end you had to talk about the stock market, and that was when the conversation became serious.”
An investment pool required close cooperation on the one hand and complete disdain for the public on the other. Generally such operations began when a number of traders banded together to manipulate a particular stock. They appointed a pool manager (who justifiably was considered something of an artist) and promised not to double-cross each other through private operations.
All such orders to buy below the market price or sell above it were kept in the specialist’s supposedly private “book.”
the illusion of activity was conveyed to the thousands of tape watchers who crowded into the brokerage offices of the country. Such activity, generated by so-called wash sales, created the impression that something big was afoot.
As the public did the buying, the pool did the selling.
Selling short is a way to make money if stock prices fall. It involves selling stock you do not currently own in the expectation of buying it back later at a lower price. It’s hoping to buy low and sell high, but in reverse order.
Nevertheless, the rules in existence today would not allow an insider to make short-swing profits from trading his own stock.
Among other things, the professor believed that the market had not yet reflected the beneficent effects of Prohibition, which had made the American worker “more productive and dependable.”
Again, there are revisionist historians who say there was a method to the madness of the stock-market boom of the late 1920s. Harold Bierman Jr., for example, in his book The Great Myths of 1929, has suggested that, without perfect foresight, stocks were not obviously overpriced in 1929. After all, very intelligent people, such as Irving Fisher and John Maynard Keynes, believed that stocks were reasonably priced.
Nevertheless, history teaches us that very sharp increases in stock prices are seldom followed by a gradual return to relative price stability. Even if prosperity had continued into the 1930s, stock prices could never have sustained their advance of the late 1920s.
The “fundamental” value of these closed-end funds consists of the market value of the securities they hold. In most periods since 1930, these funds have sold at discounts of 10 to 20 percent from their asset values. From January to August 1929, however, the typical closed-end fund sold at a premium of 50 percent.
Why are memories so short? Why do such speculative crazes seem so isolated from the lessons of history?
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 an obvious danger, but one frequently ignored.
Golconda, now in ruins, was a city in India. According to legend, everyone who passed through it became rich.
In each case, professional institutions bid actively for stocks not because they felt such stocks were undervalued under the firm-foundation principle, but because they anticipated that some greater fools would take the shares off their hands at even more inflated prices.
Questioning the propriety of such valuations became almost heretical. Though these prices could not be justified on firm-foundation principles, investors believed that buyers would still eagerly pay even higher prices. Lord Keynes must have smiled quietly from wherever it is that economists go when they die.
I recall vividly one of the senior partners of my firm shaking his head and admitting that he knew of no one with any recollection of the 1929–32 crash who would buy and hold the high-priced growth stocks. But the young Turks held sway.
