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A Short History of Financial Euphoria

When does investing turn into gambling?

tulipomaniaJohn Galbraith’s A Short History of Financial Euphoria offers a fascinating history of some of the greatest highs and lows in global financial markets. Galbraith begins the history with the infamous story of the Dutch Tulipomania in the 1630s, and progresses through history, touching on France’s Banque Royale in the 1720s, Britain’s South Sea Company in the 1720s, America’s ups and downs through the 1800s and leading up to the 1929 Great Depression, and subsequent highs and lows through the 1900s.

To avoid becoming gamblers, there are clear common themes we can learn from the bubbles and crashes of the past:  falsified economic opportunity, validation by experts and social perception.

Falsified Economic Opportunity

Investors are pummeled each day by an onslaught of information and investment opportunities. Many will spend hundreds, thousands or millions of dollars to get any possible edge on their competition: insider tips, faster computer systems, better data and reports, or sophisticated computer algorithms  to name a few. To outsiders looking in, all of these tools and information create an aura of magic—for investors driving expensive cars or wearing expensive suits, it seems as though they could never go wrong.

In today’s marketplace, there are also a number of government ‘protections’ in place that are designed to keep the common investor from taking on too much risk. Examples include regulations on credit worthiness (e.g. when purchasing real estate), requirements for becoming an ‘accredited investor’, and the formation of the SEC. Referring to the mob mania that can occur, Galbraith writes,

Regulation and more orthodox economic knowledge are not what protect the individual and the financial institution when euphoria returns, leading on as it does to wonder at the increase in values and wealth, to the rush to participate that drives up prices, and to the eventual crash and its sullen and painful aftermath. There is protection only in a clear perception of the characteristics common to these flights into what must conservatively be described as mass insanity. Only then is the investor warned and saved.

What are we protecting against? you might ask. I would suggest that the here-today-gone-tomorrow marketing strategy isn’t enough on its own to create the mob rush that drives these bubbles. Galbraith argues that we need protection from ourselves, and categorizes people into two groups:

  1. those who are persuaded that some uniquely special element or new discovery is behind the market rise, and
  2. those who perceive themselves to be more astute investors who will use their intellectual advantage to get out before the speculation cycle ends.

In addition to being aware of our own limitations, we need to add to this list an awareness of fraud. There’s an old adage, “If something seems too good to be true, it probably is.” Each major market bubble has been supported someone (or multiple people) hiding a valuable truth. For France’s Banque Royale, John Law hid the fact that his gold mining venture, the Mississippi Company, was a fake. In the 1920s, Charles Ponzi, already a convicted forger and larcenist, ran a similar real estate scheme in Florida that included “beachfront” properties that were 10-15 miles from any shore. Galbraith blames “mob mentality” for the investment fiasco, but investment decisions would be largely different if people had accurate information on which to base their decisions. Wherever a lot of money is involved, there is likely to be a lot of fraud as well.

Validation by “Experts”

In order to create the kind of economic frenzy that drives our biggest bubbles, there must also be experts who become fuel for the fire. Galbraith shares two fascinating examples from 1929:

… Paul M. Warburg, the most respected banker of his time and one of the founding parents of the Federal Reserve System, spoke critically of the then-current orgy of “unrestrained speculation” and said that if it continued, there would ultimately be a disastrous collapse, and the country would face a serious depression. The reaction to this statement was bitter, even vicious. He was held to be obsolete in his views; he was “sandbagging American prosperity”; quite possibly, he was himself short in the market. …

… Roger Babson, a considerable figure of the time who was diversely interested in statistics, market forecasting, economics, theology, and the law of gravity, specifically foresaw a crash and said, “it may be terrific.” There would be a 60- to 80-point drop in the Dow, and, in consequence, “factories will shut down…men will be thrown out of work…the vicious circle will get in full swing and the result will be a serious business depression.”

Babson’s forecast caused a sharp break in the market, and the reaction to it was even more furious than to Warburg’s. Barron’s said he should not be taken serious by anyone acquainted with the “notorious inaccuracy” of his past statements. The great New York Stock Exchange house of Hornblower and Weeks told its customers, in a remarkably resonant sentence, that “we would not be stampeded into selling stocks because of a gratuitous forecast of a bad break in the market by a well-known statistician.” Even Professor Irving Fisher of Yale University, a pioneer in the construction of index numbers, and otherwise the most innovative economist of his day, spoke out sharply against Babson. It was a lesson to all to keep quiet and give tacit support to those indulging their euphoric vision.

This type of back-lash from industry experts has two very negative affects. The first, as intended, is to dismiss any previous doubts about the market condition and to restore confidence. The second that I see is the ammunition this gives to the general public—if you share concerns similar to Babson or Warburg you could expect to receive a similar slandering response from your neighbors, friends or even family. When “experts” create this kind of fear, it’s a good time to pull out and consider yourself lucky to have not been a part.

Social Perception

Adding to the falsified economic opportunity and validation by experts, Galbraith adds two factors related to social perception:

The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. …

The second factor contributing to speculative euphoria and programmed collapse is the specious association of money and intelligence. … The basic situation is wonderfully clear. In all free-enterprise (once called capitalist) attitudes there is a strong tendency to believe that the more money, either as income or assets, of which an individual is possessed or with which he is associated, the deeper and more compelling his economic and social perception, the more astute and penetrating his mental processes. Money is the measure of capitalist achievement. The more money, the greater the achievement and the intelligence that supports it.

How do we avoid becoming gamblers?

Warren Buffett advised, “Risk comes from not knowing what you’re doing.” While many will blame fraudsters or experts for causing them to make poor investment decisions, or the government for not protecting them from their loss, the reality is that investing is risky and people should only look to themselves for their choices.

So when does investing become gambling? I would suggest that there are a few key differentiators between the two:

  • Probability: One major difference, in my opinion, between investing and gambling is the probability of success. If the odds are in your favor, you can reasonably apply portfolio theory and say that you’re investing. If the odds are against you, you’re gambling.
  • Strategy: You need to have a strategy for success. In my opinion, professional poker players can fall into this group through their ability to apply probabilities and strategies to ensure their success.
  • Knowledge: Closely linked to strategy, you need to know your investments. Even the most intelligent financial investors with proven strategies will make bad investment decisions if they don’t have a clear understanding of the target business and industry.

In Las Vegas, game players can claim having knowledge or strategy, but it doesn’t change the odds stacked against them. Similarly, the mob mania that drives some of the greatest ups and downs of our market claims a probability advantage (stocks average a 4-6% long-term annual increase), but without an investment strategy and industry knowledge it quickly becomes a gambling frenzy where only a few come out on top.

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