Part 6 (1/2)

It is cooods and services on the private market, but one of the ical alternative-has been to provide theoods and services are a political markets, but they have let us down badly, and for obvious reasons

At first sight, the private market failures, exemplified by the US system, are also obvious But e closely examine the market failures, it's the lack of information that is most serious, and the insurance market suffers the most serious consequences Ah the inter ination, and some economics, we can step back from the troubles of our current systeapore, the systees has been successful for ale of eighty, and the cost of the system (both public and private) is a thousand dollars per person-less than the cost of the bureaucracy alone in the United States Each year, the typical Singaporean pays about seven hundred dollars privately (the average Aovernment spends three hundred dol-lars per person (five tiovernovernapore's success is uncoet stuck with one side clai that we should rely on the overn-overnment or market? We've learned that the question doesn't make any sense in isolation To answer it we need to understand why ht work, and how and why they fail

We learned in chapter 3 exactly why markets work: because our choices as consuht incentives and the right inforht amount of exactly ant And we've also learned that scarcity power, externalities, and inside information can each ruin the way markets do this

In the case of health care, the market works poorly because while ant the reassurance of knowing they can afford ex-pensive medical bills, inside infor away low-risk custo preet around the probleovern forced saving and catastrophe insurance tothe power of patient choice at the heart of the system Governments can replace markets, but they will often do better to try to fix them They are unlikely to suc-ceed unless they appreciate exactly what the problee intentionally left blank

SIX

Rational Insanity

”My vision is that in a few years there will only be two or three big Internet portals-everybody will go to one of theo on the Internet That will be worth hundreds of billions of dollars If you want to succeed, you'll have to be one of those portals”

So spoke Graham Bailey (not his real na fir this passionate speech to any potential client ould listen For all I know, he believed it then and believes it now But when I heard it, I did not There were not many skeptics at the time 1998 was the year when the frenzy about the dot-co to mount

One of the most famous dot-coms was the Internet bookshop, Aue to set up com-panies na books over the internet in 1995, and in 2003 it sold over 5 bil-lion worth of ht to become profitable is remarkable, but not as remarkable as the price of its shares In 1997 A price of 18

A lot has happened since then In 1999, Amazon shares soared to over 100 At the time it was said that Aular bookshops in the world But throughout 2000, Amazon shares slid back toward 18 and beyond In the su around 8 In 2002, the coood write-ups in the financial press- but shares were still valued at less than that initial offering of 18 Yet, since then they have recovered to 40 a share Which price was the mistake: 100, or 8? Or both?

The ansould be useful, not least because Amazon's roller-coaster perfor about why share prices acted the way they did, and how they ht behave in the future?

A rando to say anything sensible about stock prices Econo rational behavior, but the more rational the behavior of stock-market investors, the more erratic the behavior of the stock market becomes

Here's why Rational people would buy shares today if it was obvious that they would go up tomorrow, and sell them if it was obvious that they would fall But this means that any forecast that shares will obviously rise to: shares will rise today instead because people will buy theer so cheap that they will ob-viously rise touess any predictable movements in the stock market or in the price of any particular share-if it's predictable then, given the money at stake, they will predict it

But that means that if investors really are rational, there won't be any predictable share movements at all All the predictability should be sucked out of the stock market very quickly because all trends will be anticipated The only thing that is left is unpre-dictable news As a result of the fact that only random newsthe stock market as a whole, should fluctuate completely at random Math-ematicians call the behavior ”a random walk”-equally likely on any day to rise as to fall

More correctly, the stockthat it should on average edge up as the o past, so that it is competitive compared with other potential invests account, or prop-erty If it was expected to edge up by more than that trend, it would already have done so, and sie up by less, or to fall, it would already have underperformed This is the reason people hold shares at all The trend doesn't alter the basic analysis, though, and on any given day the trend is dwarfed by random movements

This theory should hold even if not every investor is rational The ones who are should be enough to force theplenty ofmoney around shouldn't be too difficult, since presumably the smarter investors make more money

Should we believe the ”random walk” theory? We certainly shouldn't expect it to be absolutely true If it was, that would be a paradox: perfectly informed investors produce a random market, but a rando per-fectly informed It wouldn't be worth anybody's while to invest time and effort to analyze the market or uncover new infor the same On the other hand, aprofits to any investor willing to research them, which would then lead to fewer unexploited opportunities So point: a nearly randoh quirks to reward the informed investors who keep it nearly random

You can see the same phenomenon at work at the supermarket checkout Which line is the quickest? The si about If it was obvious which line was the quickest, people would already have joined it, and it wouldn't be the quickest any more Stand in any line and don't worry about it Yet if people really just stood in any line, then there would be predictable patterns that an expert shopper could exploit; for example, if people start at the entrance and work their way across the store, the shortest line should be back near the en-trance But if enough experts knew that, it wouldn't be the short-est any ile, and experienced shoppers are a bit better at calling the fastest lines and can prob-ably average a quicker time than the rest of us But not bythat what is true of supermarket lines is also true of stock-ht on the market, but not very much Many econo nearly as often as they are right, but not quite Our modified random walk theory tells us that this is e should expect

So, what do these econoes over thepoint is to view stock shares for what they are: a claim on the future profits of a company Here's an example Let's say there are 100 shares of tiht to 1 percent of ti as I hold the share If tiet 1 per year, forever If timharfordco, then I get 10 per year for ten years, then nothing

That's all very siht complication is that companies do not necessarily return their profits directly to shareholders Aht have been expected to pay a ”dividend” to shareholders of eight cents a share; but Amazoncom didn't pay a dividend in 2003, nor in any of the years before That doesn'tdefrauded Theoff A to expand the business If these things are done wisely, profits will rise over ti paid a dividend, Amazoncoher than it would otherwise have been, in anticipation of these later profits Even if they sell the share before any dividend is paid, they should get a better price for it because of future dividend payments

If it was easy to tell the future it would be easy to say how much it orth to own a share in timharfordcom Let's say that everybody knows ti one share will bring in 1 per year, forever How10-percent interest, that will also get me 1 per year, forever So one share in tis account at 10 percent At interest rates of 10 percent I should be willing to pay 10 for one share in timharfordcom Interest rates of 5 percent s account; in-terest rates of 1 percentto pay 100 for one share in timharfordcom with in-terest rates at 1 percent forever, because it would earn s account (This is one of the reasons that stock markets rise when interest rates are ex-pected to fall, and fall when interest rates are expected to rise) Amazonco-term interest rates in the United States of about 4 percent, I needed only 2 in a savings account at that point to earn eight cents a year Since Aht cents per share in 2003, the share should have been trading at 2, not 40 So those prices

That ”so else” is the future Real companies do not reliably e their future profitability, in whatever way they can Perhaps timharfordcom will not make 100 a year but 1 billion a year because of a drao bust tomorrow Because of this uncertainty, most reasonable people ant a discount: one risk-free share at 1 percent interest ht have been worth 100, but one risky share, expected to produce the same return of 1 a year (but who can tell?) would be worth less, perhaps 90, 70, or even 30 How much less they are worth depends on how risky the share really is, and on how much the typical investor worries about that risk

That suggests that investors in Aht cents a share, but so a share at 40 and s account and -term interest rates are 4 percent) As per share to rise to 160 and beyond to compensate them for their risk To do this, Amazoncom profits would have to rise from 35 million to about 1 billion a year

What I have just described is a view of the stock nition that in the end, shares are called shares for a reason: they give you a right to have a share in the profits of a real co run the share price has to reflect that Economists can help to work out what the fundamental value of the share is, which is what I have just done If the price of the share is lower than the fundamental value, that tells you that the share is cheap and you shouldrun, share prices have to reflect the funda-ood-value share stays undervalued forever, you should stillthe dividends In the short run, share prices should also reflect the fundamental prospects of the com-pany, too After all ould buy a share for 10 when every-body knows it is really worth 1 in the long run? And ould sell a share for 1 when everybody knows it is really worth 10 in the long run? As long as the big investors are sensible, share prices should reflect funda run and the short run But are investors sensible?

The most famous economist of the twentieth century, John Maynard Keynes, compared the stock market to a silly newspaper competition in which readers were invited to pick several pretty faces froirls closest to the general opinion

It is not a case of choosing those which, to the best of one's judge opinion genuinely thinks the prettiest We have reached the third degree where we devote our intelligences to antici-pating what average opinion expects the average opinion to be And there are sorees

Ashares I ht lots of shares in the brewer, Grolsch, because he'd been to lots of parties around the City of London and Grolsch beer was being served at all of them Other beers, which had previously been popular, like Stella Artois or Heineken, seemed to have disappeared from the scene Naively, I told hiood indicator of Grolsch's ide sales; Grolsch could be doing well in the City but badly everywhere else, in which case the co the shares would have been a mistake The investor told me that he knew that was true, but it didn'tin the City, lots of City investors would figure it was made by a successful coo up-for a while-and he could sell at a profit The fundamentals onlyenough for the real picture, whatever it was, to become clear And as the real picture? Over the next year, Grolsch shares fell by about a third froht back in just a couple ofin March 2005, they are almost exactly where they e first had the conversation

The Grolsch method is not interested in the value of the share It's sie of what ivenknow about rational stock markets and the random walk, ould we expect investors to make such easily exploitable mistakes?

Rational fools Why indeed? Consider the story of Tony Dye, Chief Invest-es investe clients Tony Dye concluded in 1996 that at a level of 4000, the FTSE 100 (the index that reflects the perforest companies) was overvalued, and he moved a chunk of his clients' s ac-count Having withdrawn 7 billion froed day by day on his decision by his clients, his peers, and the newspapers He was mocked and nicknahout the late 1990s, Dye looked increasingly stupid In 1999, Philips & Drew lost er Based on returns to clients, it ranked sixty-six out of sixty-seven competitors in the final three months of 1999 Dye continued to insist that the stock market was overvalued, shunned Internet and telecom shares, and kept an unusual proportion of his client's investments in cash The end was inevitable: his early retire of March 2000, and the broad conclusion was that he had been forced out The Ti joke,” and Dye's successor acknowledged that Dye had suffered: ”That's a lonely place The last few years have not been the easiest in terms of the flak he has had to put up with”

Dye lost his job, but he was right Before Philips & Drew had tiy, the stock y stocks plummeted The stock market as a whole slumped The unfashi+onable ”value” shares, which Dye had been holding, did well, and cash was also better than crashi+ng Internet shares Philips & Drew soared to the top of the pension fund perfor its clients 64 percent in the three months up to June 2000-the equivalent ofmarket The FTSE fell and fell and fell, from over 6400 at the time of Mr Dye's departure to under 3300 three years later Dye had concluded in 1996 that his clients would be better off selling shares with the s account He was eventually proved right seven years later

Tony Dye was right, but was he sensible? The hundreds of fundkept their jobs because they were all wrong in a big herd Tony Dye de-cided to follow his own path He was vindicated in the end, but not before he had been ridiculed by the press, abandoned by his clients, and forced out by his eers face lop-sided incentives: if they decide to take a different view from the crowd, they in a few clients if they are successful but lose their jobs if they are not Much safer to run with the herd

This isn't to say that share prices are completely out of touch with reality-siers, whopaid to fol-low fashi+on instead of pick the right shares That's bound tothe long view It can take many years for those mistakes to become apparent Who is to say for sure that the Internet bubble really was a bubble? The trutha mistake today when stock prices have fallen so far There are no definitive answers, but I find that taking a long, long look back certainly raises the right questions At the peak of the et people to buy into the stock market, or a stock-raph of stock prices, which looked so like this: Does the stock market do this?

50 45 40 35 30 25 20 15 10 5 0

1980 1990 2000 Source: shi+ller 2001

The idea of this graph is to show you that the stock market (in this case, a much-quoted US stock index, the S&P 500) has climbed very quickly, and if you had invested in the early 1980s you would have done very nicely indeed