Remember, just to stay even, your investments have to produce a rate of return equal to inflation. Inflation in the United States and throughout most of the developed world fell to the 2 percent level in the early s, and some analysts believe that relative price stability will continue indefinitely. They suggest that inflation is the exception rather than the rule and that historical periods of rapid technological progress and peacetime economies were periods of stable or even falling prices.
It may well be that little or no inflation will occur during the first decades of the twenty-first century, but I believe investors should not dismiss the possibility that inflation will accelerate again at some time in the future. Moreover, productivity improvements are harder to come by in some service-oriented activities. Thus, it would be a mistake to think that upward pressure on prices is no longer a worry. If inflation were to proceed at a 2 to 3 percent rate—a rate much lower than we had in the s and early s—the effect on our purchasing power would still be devastating.
The following table shows what an average inflation rate of approximately 4 percent has done over the — period. My morning newspaper has risen 3, percent. Investing requires work, make no mistake about it. Romantic novels are replete with tales of great family fortunes lost through neglect or lack of knowledge on how to care for money.
Free enterprise, not the Marxist system, caused the downfall of the Ranevsky family: They had not worked to keep their money.
Even if you trust all your funds to an investment adviser or to a mutual fund, you still have to know which adviser or which fund is most suitable to handle your money. Armed with the information contained in this book, you should find it a bit easier to make your investment decisions. Most important of all, however, is the fact that investing is fun.
A successful investor is generally a well-rounded individual who puts a natural curiosity and an intellectual interest to work to earn more money. 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. Millions of dollars have been gained and lost on these theories.
To add to the drama, they appear to be mutually exclusive. An understanding of these two approaches is essential if you are to make sensible investment decisions. It is also a prerequisite for keeping you safe from serious blunders.
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. It is difficult to ascribe to any one individual the credit for originating the firm-foundation theory.
Eliot Guild is often given this distinction, but the classic development of the technique and particularly of the nuances associated with it was worked out by John B. In The Theory of Investment Value, Williams presented an actual formula for determining the intrinsic value of stock. Williams based his approach on dividend income.
Discounting basically involves looking at income backwards. Williams actually was serious about this. 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.
It received a further boost under the aegis of Professor Irving Fisher of Yale, a distinguished economist and investor. The logic of the firm-foundation theory is quite respectable and can be illustrated with common stocks.
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. Now the slippery little factor of future expectations sneaks in. Security analysts must estimate not only long-term growth rates but also how long an extraordinary growth can be maintained. When the market gets overly enthusiastic about how far in the future growth can continue, it is popularly held on Wall Street that stocks are discounting not only the future but perhaps even the hereafter.
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. The firm-foundation theory is not confined to economists alone. It was that easy. Of course, instructions for determining intrinsic value were furnished, and any analyst worth his or her salt could calculate it with just a few taps of the personal computer.
John Maynard Keynes, a famous economist and successful investor, enunciated the theory most lucidly in 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.
According to Keynes, the firm-foundation theory involves too much work and is of doubtful value. Keynes practiced what he preached. In the depression years in which Keynes gained his fame, most people concentrated on his ideas for stimulating the economy.
It was hard for anyone to build castles in the air or to dream that others would. Nevertheless, in his book The General Theory of Employment, Interest and Money, Keynes devoted an entire chapter to the stock market and to the importance of investor expectations.
With regard to stocks, Keynes noted that no one knows for sure what will influence future earnings prospects and dividend payments. The smart player recognizes that personal criteria of beauty are irrelevant in determining the contest winner. A better strategy is to select those faces the other players are likely to fancy. This logic tends to snowball. After all, the other participants are likely to play the game with at least as keen a perception. So much for British beauty contests.
The newspaper-contest analogy represents the ultimate form of the castle-in-the-air theory of price determination. An investment is worth a certain price to a buyer because she expects to sell it to someone else at a higher price. The investment, in other words, holds itself up by its own bootstraps. The new buyer in turn anticipates that future buyers will assign a still higher 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. Robert Shiller, in his best-selling book Irrational Exuberance, argues that the mania in Internet and high-tech stocks during the late s can be explained only in terms of mass psychology.
At universities, so-called behavioral theories of the stock market, stressing crowd psychology, gained favor during the early s at leading economics departments and business schools across the developed world. In an exchange economy the value of any asset depends on an actual or prospective transaction.
He believed that every investor should post the following Latin maxim above his desk: Res tantum valet quantum vendi potest. A thing is worth only what someone else will pay for it.
My first task will be to acquaint you with the historical patterns of pricing and how they bear on the two theories of pricing investments. It was Santayana who warned that if we did not learn the lessons of the past we would be doomed to repeat the same errors. Therefore, in the pages to come I will describe some spectacular crazes— both long past and recently past. Some readers may pooh- pooh the mad public rush to buy tulip bulbs in seventeenth- century Holland and the eighteenth-century South Sea Bubble in England.
This is one of the peculiarly dangerous months to speculate in stocks in. In their frenzy, market participants ignore firm foundations of value for the dubious but thrilling assumption that they can make a killing by building castles in the air. Such thinking has enveloped entire nations. The psychology of speculation is a veritable theater of the absurd. Several of its plays are presented in this chapter. In each case, some of the people made money some of the time, but only a few emerged unscathed.
History, in this instance, does teach a lesson: Although the castle-in-the-air theory can well explain such speculative binges, outguessing the reactions of a fickle crowd is a most dangerous game. It would appear that not many have read the book.
Skyrocketing markets that depend on purely psychic support have invariably succumbed to the financial law of gravitation. Unsustainable prices may persist for years, but eventually they reverse themselves.
Such reversals come with the suddenness of an earthquake; and the bigger the binge, the greater the resulting hangover. Few of the reckless builders of castles in the air have been nimble enough to anticipate these reversals and to escape when everything came tumbling down.
Its excesses become even more vivid when one realizes that it happened in staid old Holland in the early seventeenth century. The events leading to this speculative frenzy were set in motion in when a newly appointed botany professor from Vienna brought to Leyden a collection of unusual plants that had originated in Turkey.
Over the next decade or so, the tulip became a popular but expensive item in Dutch gardens. 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. Slowly, tulipmania set in. Then they would buy an extra-large stockpile to anticipate a rise in price. Tulip-bulb prices began to rise wildly. The more expensive the bulbs became, the more people viewed them as smart investments.
People who said the prices could not possibly go higher watched with chagrin as their friends and relatives made enormous profits.
The temptation to join them was hard to resist. Bulb prices reached astronomical levels. Part of the genius of financial markets is that when there is a real demand for a method to enhance speculative opportunities, the market will surely provide it.
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.
An option on a tulip bulb currently worth guilders, for example, would cost the buyer only about 20 guilders. If the price moved up to guilders, the option holder would exercise his right; he would buy at and simultaneously sell at the then current price of He then had a profit of 80 guilders the guilders appreciation less the 20 guilders he paid for the option.
Thus, he enjoyed a fourfold increase in his money, whereas an outright purchase would only have doubled his money. Such devices helped to ensure broad participation in the market. The same is true today. The history of the period was filled with tragicomic episodes. One such incident concerned a returning sailor who brought news to a wealthy merchant of the arrival of a shipment of new goods.
The merchant rewarded him with a breakfast of fine red herring. It was a costly Semper Augustus tulip bulb. The sailor paid dearly for his relish—his no longer grateful host had him imprisoned for several months on a felony charge. Historians regularly reinterpret the past, and some financial historians who have reexamined the evidence about various financial bubbles have argued that considerable rationality in pricing may have existed after all.
One of these revisionist historians, Peter Garber, has suggested that tulip- bulb pricing in seventeenth-century Holland was far more rational than is commonly believed. Garber makes some good points, and I do not mean to imply that there was no rationality at all in the structure of bulb prices during the period.
The Semper Augustus, for example, was a particularly rare and beautiful bulb and, as Garber reveals, was valued greatly even in the years before the tulipmania. But Garber can find no rational explanation for such phenomena as a twenty-fold increase in tulip-bulb prices during January of followed by an even larger decline in prices in February.
Apparently, as happens in all speculative crazes, prices eventually got so high that some people decided they would be prudent and sell their bulbs. Soon others followed suit. Like a snowball rolling downhill, bulb deflation grew at an increasingly rapid pace, and in no time at all panic reigned.
Government ministers stated officially that there was no reason for tulip bulbs to fall in price—but no one listened. Dealers went bankrupt and refused to honor their commitments to buy tulip bulbs. And prices continued to decline. Down and down they went until most bulbs became almost worthless—selling for no more than the price of a common onion. Right you are, but years ago in England this was one of the hottest new issues of the period.
And, just as you guessed, investors got very badly burned. The story illustrates how fraud can make greedy people even more eager to part with their money.
At the time of the South Sea Bubble, the British were ripe for throwing away money. A long period of prosperity had resulted in fat savings and thin investment outlets.
In those days, owning stock was considered something of a privilege. They reaped rewards in several ways, not least of which was that their dividends were untaxed. Also, their number included women, for stock represented one of the few forms of property that British women could possess in their own right. 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. From the very beginning, the South Sea Company reaped profits at the expense of others. Holders of the government securities to be assumed by the company simply exchanged their securities for those of the South Sea Company.
Not a single director of the company had the slightest experience in South American trade. But even this venture did not prove profitable, because the mortality rate on the ships was so high. The directors were, however, wise in the art of public appearance. An impressive house in London was rented, and the boardroom was furnished with thirty black Spanish upholstered chairs whose beechwood frames and gilt nails made them handsome to look at but uncomfortable to sit in.
In the meantime, a shipload of company wool that was desperately needed in Vera Cruz was sent instead to Cartagena, where it rotted on the wharf for lack of buyers. To further his purpose, Law acquired a derelict concern called the Mississippi Company and proceeded to build a conglomerate that became one of the largest capital enterprises ever to exist.
The Mississippi Company attracted speculators and their money from throughout the Continent. At one time the inflated total market value of the stock of the Mississippi Company in France was more than eighty times that of all the gold and silver in the country.
Meanwhile, back on the English side of the Channel, a bit of jingoism now began to appear in some of the great English houses. Why should all the money be going to the French Mississippi Company? What did England have to counter this? This was free enterprise at its finest. This was boldness indeed, and the public loved it. Fights broke out among other investors surging to buy. But the public was ravenous. On June 15 yet another issue was floated. This time the payment plan was even easier—10 percent down and not another payment for a year.
Half the House of Lords and more than half the House of Commons signed on. The speculative craze was in full bloom. Not even the South Sea Company was capable of handling the demands of all the fools who wanted to be parted from their money. Investors looked for other new ventures where they could get in on the ground floor. Just as speculators today search for the next Google, so in England in the early s 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. Increasingly the promotions involved some element of fraud, such as making boards out of sawdust.
There were nearly one hundred different projects, each more extravagant and deceptive than the other, but each offering the hope of immense gain. Like bubbles, they popped quickly—usually within a week or so. The public, it seemed, would buy anything.
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. 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. Whom the gods would destroy, they first ridicule. Signs that the end was near appeared with the issuance of a pack of South Sea playing cards.
Each card contained a caricature of a bubble company, with an appropriate verse inscribed underneath. One of these, the Puckle Machine Company, was supposed to produce machines discharging both round and square cannonballs and bullets. Puckle claimed that his machine would revolutionize the art of war. Many individual bubbles had been pricked without dampening the speculative enthusiasm, but the deluge came in August with an irreparable puncture to the South Sea Company.
Realizing that the price of the shares in the market bore no relationship to the real prospects of the company, the directors and officers sold out in the summer. The news leaked and the stock fell. Soon the price of the shares collapsed and panic reigned. The chart below shows the spectacular rise and fall of the stock of the South Sea Company. Government officials tried in vain to restore confidence, and a complete collapse of the public credit was barely averted.
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. To protect the public from further abuses, Parliament passed the Bubble Act, which forbade the issuing of stock certificates by companies.
For more than a century, until the act was repealed in , there were relatively few share certificates in the British market. Could the same sort of thing happen in more modern times? America, the land of opportunity, had its turn in the s. And given our emphasis on freedom and growth, we produced one of the most spectacular booms and loudest crashes civilization has ever known. Conditions could not have been more favorable for a speculative craze. The country had been experiencing unrivaled prosperity.
Such analogies were even made in the opposite direction. The price increases are illustrated in the table below. Nevertheless, only about one million people owned stocks on margin in Still, the speculative spirit was at least as widespread as in the previous crazes and was certainly unrivaled in its intensity. More important, stock-market speculation was central to the culture. Manipulation on the stock exchange set new records for unscrupulousness. No better example can be found than the operation of investment pools.
One such undertaking raised the price of RCA stock 61 points in four days. 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. The pool manager accumulated a large block of stock through inconspicuous buying over a period of weeks.
If possible, he also obtained an option to buy a substantial block of stock at the current market price. Pool members were in the swim with the specialist on their side. The book gave information about the extent of existing orders to buy and sell at prices below and above the current market. Now the real fun was ready to begin. Generally, at this point the pool manager had members of the pool trade among themselves. For example, Haskell sells shares to Sidney at 40, and Sidney sells them back at 40?.
Next comes the sale of a 1,share block at 40? These sales were recorded on ticker tapes across the country, and 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. Now tipsheet writers and market commentators under the control of the pool manager would tell of exciting developments in the offing. If all went well, and in the speculative atmosphere of the —29 period it could hardly miss, the combination of tape activity and managed news would bring the public in.
The pool manager began feeding stock into the market, first slowly and then in larger and larger blocks before the public could collect its senses. At the end of the roller-coaster ride, the pool members had netted large profits and the public was left holding the suddenly deflated stock.
Many individuals, particularly corporate officers and directors, did quite well on their own. In July Mr. Wiggin became apprehensive about the dizzy heights to which stocks had climbed and no longer felt comfortable speculating on the bull side of the market.
He was rumored to have made millions in a pool boosting the price of his own bank. 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.
Immediately after the short sale, the price of Chase stock began to fall, and when the crash came in the fall the stock dropped precipitously. When the account was closed in November, he had netted a multimillion-dollar profit from the operation. Conflicts of interest apparently did not trouble Mr. In fairness, it should be pointed out that he did retain a net ownership position in Chase stock during this period.
Nevertheless, the rules in existence today would not allow an insider to make short-swing profits from trading his own stock. On September 3, , the market averages reached a peak that was not to be surpassed for a quarter of a century. As Babson implied, he had been predicting the crash for several years and he had yet to be proven right. In the last frantic hour of trading, American Telephone and Telegraph went down 6 points, Westinghouse 7 points, and U.
Steel 9 points. It was a prophetic episode. After the Babson Break the possibility of a crash, which was entirely unthinkable a month before, suddenly became a common subject for discussion. Confidence faltered. September had many more bad than good days. At times the market fell sharply. Bankers and government officials assured the country that there was no cause for concern.
The declines in stock prices had led to calls for more collateral from margin customers. Unable or unwilling to meet the calls, these customers were forced to sell their holdings.
This depressed prices and led to more margin calls and finally to a self-sustaining selling wave. The volume of sales on October 21 zoomed to more than 6 million shares. The ticker fell way behind, to the dismay of the tens of thousands of individuals watching the tape from brokerage houses around the country.
Nearly an hour and forty minutes had elapsed after the close of the market before the last transaction was actually recorded on the stock ticker.
Many issues dropped 40 and 50 points during a couple of hours. Only October 19 and 20, , rivaled in intensity the panic on the exchange. More than A million-share day in would be equivalent to a multibillion-share day in because of the greater number of listed shares. Prices fell almost perpendicularly, and kept on falling, as is illustrated by the following table, which shows the extent of the decline during the autumn of and over the next three years.
Again, there are revisionist historians who say there was a method to the madness of the stock-market boom of the late s. Harold Bierman Jr. After all, very intelligent people, such as Irving Fisher and John Maynard Keynes, believed that stocks were reasonably priced.
Bierman goes on to argue that the extreme optimism undergirding the stock market might even have been justified had it not been for inappropriate monetary policies. 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 s, stock prices could never have sustained their advance of the late s. In most periods since , these funds have sold at discounts of 10 to 20 percent from their asset values. From January to August , however, the typical closed-end fund sold at a premium of 50 percent.
Moreover, the premiums for some of the best-known funds were astronomical. Goldman, Sachs Trading Corporation sold at twice its net asset value. Tri-Continental Corporation sold at percent of its asset value. It was irrational speculative enthusiasm that drove the prices of these funds far above the value at which their individual security holdings could be purchased. Burton G.
Malkiel shows how to analyze the potential returns, not only for stocks and bonds but also for the full range of investment opportunities, from money market accounts and real estate investment trusts to insurance, home ownership, and tangible assets like gold and collectibles. You succeed. Yet you believe you can do better. Since the marketplace determined to take a break with Netflix, your results are less as you thought they would certainly be.
You like going to Shake Shack. So you look up its stock symbol and recognize it had a significant run because its IPO. At a household meeting, you hear your fresh-out-of-college nephew talk about just how much he likes his task as an information researcher at Hey there Fresh, where they make use of an unbelievable tool called Tableau.
So, you decide to buy every one of these companies. At first, you succeed in Shake Shack. So, you end up with typical results. Tableau does fantastic and also you keep listening to good things regarding it. Hey there Fresh has a remarkable service version however, for some reason the stock has actually been trading in ranges for ever.
Score: 3. A Random Walk Down Wall Street has long been established as the first book to purchase when starting a portfolio.
Score: 4. Here Andrew W. Lo and A. In this volume, which elegantly integrates their most important articles, Lo and MacKinlay find that markets are not completely random after all, and that predictable components do exist in recent stock and bond returns.
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