Part 3 (1/2)
-Sir Isaac Newton, PHILOSOPHIAE NATURALIS PRINCIPIA MATHEMATICA In July 1936, only a few months after the release of The General Theory, Keynes acquired at auction a large steel trunk frolish aristocratThe box contained soe ' s iant of science, the son of an illiterate farhtenment In the words of Alexander Pope: Nature and Nature ' s laws lay hid in night: God said, Let Newton be!
and all was light
In the year 1666 alone - the ” Year of Wonders ” - the young Newton, locked away at hoe ' s colleges, invented differential calculus, formulated the
Law of Universal Gravitation, and proposed his Theory of Light He was celebrated as the discoverer of ” the grand secret of the whole Machine,” a ence snuffed out the shad-ows of h Priest of Reason was, however, so of a heretic behind closed doors Much of Newton ' s early life was spent in his ” elaboratory,” where, according to his assistant, his ” che beyond the reach of hueometer of the universe - despite the mechanistic conception of the world he propounded, he was obsessed with alchemy and the supernatural He never completely accepted the notion of ” inaniorated by unseen ” animal spirits ” in the ether
Neas also an ardent pursuer of material wealth Unsuccessful in his alcheold, he eventu-ally found his own Philosopher ' s Stone as Master of the Royal Mint In this capacity, Newton oversaw the recoinage of England ' s currency, receiving a com extraordinarily rich in the process In 1720, toward the end of his long life, Newton ventured some of his fortune in stock of the South Sea Co for a considera-ble prot, Neas induced by rising stock prices to re - enter the market The second time around he was not so lucky The South Sea Bubble burst and Newton lost around 20,000 - more than 6 million in today ' s ravity in the world of nance, he remarked ruefully, ” I can calculate the motions of heavenly bodies, but not the madness of people”
Like his hero Newton, Maynard Keynes also learned the hard way that - largely due to the unavoidable fact of uncertainty -nancial markets were sometimes buffeted by unpredictable squalls of ” whim or sentiment or chance ” and prey to ” purely irrational waves of opti to anticipate the quicksil-ver tacks of the- footed on more than one occasion - Keynes nally concluded that those who run with the crowd are apt to be tra herd, he decided, than be torn asunder in the running of the bulls or the ight froreatest part of our Concernht
-John Locke, AN ESSAY CONCERNING HUMAN UNDERSTANDING A author-ity on Newton, a position enhanced by his acquisition of the scientist ' s papers Keynes brought to the world ' s attention the occult - obsessed,hies, and one foot treading a path for modern sci-ence” He also appropriated Newton ' s idea of ” ani that in the supposedly mechanistic world of nancialother than a clinical analysis of expected outcomes
Keynes ' General Theory explained that nancial markets are not only prone to periodic informational cascades that compromise ef ciency, but also that investors cannot be the rational actors of classical theory because a cold calculation of expected outcomes is simply not possible With incontrovertible common sense, Keynes observed that there are some events for which ” there is no scientic basis on which to for fact is the extree on which our estie of the factors which will govern the yield of an investible If we speak frankly, we have to ad the yield ten years hence of a railway, a copper oodwill of a patentin the City of London a
” Wishes are fathers to thoughts,” Keynes once observed Re the case for ef cient lossed over the fact that ” core risk ” - uncertainty that cannot be assigned a probability - precludes a precise calculation of a stock ' s expected yield Keynes therefore rejected orthodox theory ' s blithe assu a security, nancial ood Benthaes and disadvantages, eachto be summed” Despite the assumptions of classical theory, there are, as Keynes pointed out, many factors about which ” we simply do not know”
My Indecision Is Final Prediction is very difcult, especially about the future
-Niels Bohr (attributed) Keynes invoked a paradox beloved of philosophers - that of ” Buridan ' s ass ” - to illustrate why ” the necessity for action and for decision com-pels us as practical men ” to overlook the ” aard fact ” that a uniquely correct valuation of a stock is impossible Buridan ' s ass is an apocryphal beast that, faced with two equally attractive and accessible bales of hay, starved while deliberating which one was preferable Like the donkey of the parable, stock market participants - if they were to attempt to apply a purely rational approach to their investment decisions - would also be rendered i ” what ifs ” of an unknowable future Instead, they resort to less analytical factors when assessing stockin the position of Buridan ' s ass, we fall backonconcerned with the evaluation of consequences, but are decided by habit, instinct, preference, desire, will etc
The stock market player is ih not rational, are nevertheless legitiovernment bonds - which pay axed coupon, and whose present investment value can be deterht zone of aap is a blank canvas on which the investor projects his or her most fervent hopes or darkest fears” Anie to action rather than inaction,” as Keynes de ned thee the uncertainty gap inherent in any investment decision
The investor, Keynes concluded, is not the perfectly knowledge-able calculating machine of orthodox theory Despite the assertions of efcient markets proponents, stock overned by purely rational factors Investor psychology plays an integral role in the decision to buy, sell, or hold a stockAs Keynes sue proportion of our positive activities depend on sponta-neous optimism rather than on a mathematical expectation, whether moral or hedonistic or econo positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of anie of quantita-tive bene tsat Shadows The stock market has predicted nine out of the last ve recessions
-Paul Samuelson, NEWSWEEK Not only does the presence of uncertainty mean that investors fall back on their ” state of con dence ” or ” ani invest-erates the impact of near - term factors on a stock ' s performance In hisA Treatise on Money, published in 1930, Keynes noted:how sensitive - over - sensitive if you like - to the near future, about which we may think we know a little, even the best - infor about the more remote future
Not unreasonably, Keynes conceded, investors attach greater weight to matters about which they are relatively h they may be less decisively relevant to the issue than other facts about which our knowledge is vague and scanty” In consequence:the facts of the existing situation enter, in a sense disproportion-ately, into the for - ter situation and to project it into the future, modied only to the extent that we have e
The broad assu state of affairs will con-tinue inde nitely ” means that: Day - to - dayuctuations in the prots of existing investnicant character, tend to have an altogether excessive, and even an absurd, inuence on the market
As an example of this tendency, Keynes claimed - not without a touch of hyperbole - that ” the shares of Aher price in suh than in winter when no one wants ice ” and that the ” recurrence of a bank - holiday may raise the market valuation of the British railway system by several million pounds”
The focus on the shorter term means that investor expectations - and therefore stock prices - are extremely sensitive to new information, and that: Faced with the perplexities and uncertainties of the modern world, market values will uctuate ht of after - events
In simple terms, the unavoidable fact of uncertainty prompts stockstock prices to overshoot Empirical evidence supports Keynes ' thesis - studies show that stock prices display far greater volatility than would be expected relative to changes in underlying earnings and dividends Exacerbating this tendency to overweight new infore investor - his or her propensity to feelnancial losses ains Risk aversion ative news, as investors overdis-count security prices affected by unfavorable new information
Con dence Trick Randolph Duke: Exactly why do you think the price of pork bellies is going to keep going down,William?
Billy Ray Valentine: Okay, pork belly prices have been dropping allfor it to hit rock bottom, so they can buy lowWhich means that the people n the pork belly contracts are saying,” Hey, we ' re losing all our daonna have no rip! And onnaright now, they ' re screaet out before the price keeps drop-ping They ' re panicking out there right now, I can feel it
-TRADING PLACES The stock market, Keynes deon of efciency that orthodox nancial theorists claimed it to be It was prone to informational cascades - episodes where prices would sobll in one direction or the other merely because momentum had seized the market - and, more fundamentally, investment decisions were impelled to some extent by necessarily nonrational factors As Keynes pointed out, due to the inescapable fact of uncertainty, ” all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield”
To take but one exarapher of Marcel Proust, that rich but troubled neurasthenic of the early twentieth century, noted that the French author:made many ruinous investments but refused to listen to his bankerMore often than not he purchased a stock because of its poetic naanyika Railway,” ” The Australian Gold Mines ” ); in fact, these stocks were a substitute for the travels to exotic places he longed to make
Like Tolstoy ' s unhappy families, all irrational investors are irrational in their own particular way Proust ' s purchases, made in the antiseptic euided by the evocativeness of a coed with associations as his tea -soaked madeleine biscuits Other, perhaps less poetically inclined, ht equally be inuenced by a perceived trend in a stock ' s price, an inside tip, or what the chap next door is doing
Keynes ' view of the stock market was diametrically opposed to that of orthodox nancial theory, where, as the reference books inform the reader, ” investors are unromantically concerned with therm' s cash ows and the portion of those cash ows to which they are entitled” In the make - believe world of classical theory, the stock market was conceived as an infalliblethe present value of future income from a security Real world complications such as uncertainty and the state of investor condence were conveniently dis-regarded in the interests of theoretical elegance Orthodox theory did not admit the possibility that the virus of anienerate numbers which could depart widely from any reasonable assessency Under certain circulomeration of men presents new characteristics very different fro it
-Gustave Le Bon, THE CROWD Econoreatly inuenced by discoveries in the ” hard ” sciences - the clockwork precision of Newtonian physics was re ected in classical theory ' s mechanistic conception of the world; Darwin ' s doc-trine of survival of the ttest inspired the muscular free - trade policies of the Victorian era; and Einstein ' s bizarre theories of relativity were mirrored in the Keynesian universe, where money - like tiued, however, that econo resemblance to science in at least one key respect In the discipline of economics, he asserted,” the atomic hypothesis that has worked so splendidly in phys-ics breaks down,” and consequently: We are faced at every turn with the probleanic unity, of dis-creteness, of discontinuity - the whole is not equal to the sues produce large effects, the assueneous continuum are not satis ed
The economy, as Keynes noted, exhibits what have coent properties ” : complex, someti out of the multiplicity of interactions between its individual constituents
Behavior in the atomistic world of microeconomics cannot always be extrapolated to the sphere of ates Keynes ' most famous example of the ” fallacy of composition ” was the so - called Paradox of Thrift - which notes that saving is good for the individual, but if all individuals increase their savings then aggregate des for the population as a whole Similarly, the stock market - one of the purest expressions of the free ent proper-ties, where individual behavior mutates into mob irrationality Even for someone of Keynes ' protean interests and abilities, the stock market was siuess
A Sentimental Education Don ' t try to buy at the bottom and sell at the topThis cannot be done - except by liars
-Bernard Baruch, MY OWN STORY Keynes eventually concluded that because of the utter capriciousness and complexity of the stock” approach rarely rewarded its folloith nancial successAs he conceded to a colleague in May 1938: I can only say that I was the principal inventor of credit cycle invest- in detail on distinctly different lines over a period of nearly twenty years, which has been full of ups and downs; and I have not seen a single case of a success having beennot only deht ” and required ” phenomenal skill to make much out of it,” but that transaction expenses from such a necessarily active invest prots He expanded on this thee Estates Committee:I am clear that the idea of wholesale shi+fts [out of and into stocks at different stages of the business cycle] is for various reasons imprac-ticable and indeed undesirable Most of those who attempt it sell too late and buy too late, and do both too often, incurring heavy expenses and developing too unsettled and speculative a state of mind
Keynes ' realization that there was no e in his invest the Great Crash, he co an investor rather than a speculator - one who focuses on likely future performance rather than past trends, expected yield rather than disposal price, particular stocks rather than the broader index, and rely-ing on his own judgment rather than that of the market Simply stated, Keynes switched fros in thein the Inferno ” It ' s always best on these occasions to do what the ested Mr Snodgrass” Shout with the largest,” replied Mr Pickwick
-Charles dickens, THE PICKWICK PAPERS ” Tulipoen of anihers of the seventeenth century As Charles Mackay recalls in his catalog of human folly, Extraordinary Popular Delusions and the Madness of Crowds, the ” rage to possess ” tulips was so powerful that: nobles, citizens, farmers, mechanics, seamen, footmen, maidser-vants, even chimney - sweeps and old clothesworades converted their property in cash, and invested it inowers
Speculative fervor for the exotic plants was such that traders, in an early version of a futures contract, started to sell the rights to bulbs they had not yet even plantedThis innovation - dismissively labeled windhandel, or ” wind trade,” by those untouched by themoved from the physical to the abstract