Warren Buffett advises investors trying to get to grips with the current market.
Late last year, legendary investor Warren Buffett had this advice for investors trying to get to grips with the current market:
"If you understand chapters 8 and 20 of The Intelligent Investor (Ben Graham, 1949) and chapter 12 of the General Theory of Employment, Interest and Money (John Maynard Keynes, 1936), you don't need to read anything else and you can turn off your TV."
So I decided to take a closer look at these specific chapters and what they might mean for us today, starting with the Keynes chapter "The State of Long-Term Expectations".
According to Keynes, the main cause of economic fluctuations is the instability of investment demand, which is in turn caused by the volatility of expectations of the future yield of investment. Our expectations of future returns vary from optimistic to pessimistic, and we invest accordingly.
Our knowledge is very limited
Those expectations of future returns are based in part on information, some of which we are relatively sure about, and some of which is very uncertain, and we pay most attention to the information about which are are most confident.
The problem is that the information about which we are confident is not necessarily the most relevant to our investment, while facts about which we know little may be very important.
And as we are most certain about the present, our usual practice is "to take the existing situation and to project it into the future, modified only to the extent that we have more or less definite reasons for expecting a change".
But we go ahead anyway
On this flimsy model of the future, entrepreneurs hope to build businesses. These optimistic people create things and get things done, but Keynes questions whether these are always the right things from return-on-investment point of view.
"It is probable that the actual average results of investments, even during periods of progress and prosperity, have disappointed the hopes which prompted them ... If human nature felt no temptation to take a chance, no satisfaction (profit apart) in constructing a factory, a railway, a mine or a farm, there might not be much investment merely as a result of cold calculation".
A stock market changes the game
In the past, the owners of these enterprises were effectively locked in, unable to sell easily, which obviously increased their risk, but the existence of a market on which to trade shares in their businesses changes that.
"It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and II in the morning and reconsider whether he should return to it later in the week."
In this way, the stock exchange reduces risk by making investments liquid for individuals, but this makes investment as a whole much more volatile, since investors can buy and sell at a moment's notice.
Share prices affect investment
The market valuation of a business has an effect on people's inclination to invest:
"There is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit."
The beauty contest
As the actual prospects for an investment are effectively unknowable, share prices depend more on the mood of the market, which can fluctuate wildly. That being the case, investors must try to predict future market sentiment.
"It is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence."
The game becomes a beauty contest, in which we must select not what we regard as the most attractive investment, but what we think others will view as the most attractive investment. But if those others are playing the same game, then we must guess what the rest of the market thinks the rest of the market would select … and so on.
He believes it is harder to properly evaluate a business than to time the market, a belief that many readers of The Motley Fool would dispute.
Speculation versus enterprise
Keynes uses the term 'speculation' for the activity of forecasting the psychology of the market, and the term 'enterprise' for the activity of forecasting the prospective yield of assets over their whole life.
"Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done".
"There is no clear evidence … that the investment policy which is socially advantageous coincides with that which is most profitable."
"It is usually agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of stock exchanges".
What it means for us now
Based in these statements, Keynes would appear to favour a Tobin tax.
Continuing the paternalistic tenor, he toys with the idea of making it illegal to save, forcing us to either consume or invest, which would stimulate consumption when we are pessimistic about investments, although he does not appear to be putting this forward as a serious proposal.
Keynes declared himself to be "somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest", and expected to see states taking more of a central planning approach to investment, which assumes that governments and civil servants are in a position to decide the allocation of capital.
According to Lord Skidelsky, who wrote a major biography of Keynes, many Keynesians see this chapter as containing the 'vision' of The General Theory, and of the Keynesian movement, both in its attack on the ethics of capitalism and in its rejection of calculability in human affairs.
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