For the 10 months beginning March and concluding in December, I will re-read and then provide a review of one of the timeless investment classics that I keep and refer to on the bookshelf within arm’s reach of my desk. We’ll start with what I consider the best book ever written on market psychology -- published in 1841; I'll include midway through this series the book Warren Buffett calls “by far the best book on investing ever written;” and proceed through to my final choice, published in 1967. These classics will cover a 126 year span of investing history.
Not to disparage any investment book hot off the presses in 2010 or written in the last 40 years (including my own!) but to be considered a “classic” the book must have stood the test of time. I figure 40 to 125 years should provide a pretty good crucible. I believe these books can teach us more about human nature, investing, and wealth and risk management than anything written before or since. Maybe in 2011 I’ll tackle some of the great investing books written during the introspective 1970s and beyond. All of the 10 I will re-read and review this year are still in print, still selling today. There’s a reason. Each offers still-fresh, unique, and well-worth-reading insights that will simply make you a more relaxed, more confident and better investor… (Of course, if you want to buy my book as well, who am I to discourage you? //grins//)
#1 -- 1841’s Extraordinary Popular Delusions and the Madness of Crowds
You may be excused for wondering what a book published 169 years ago could possibly teach you about today’s markets. Not only had CDS’s and sub-prime mortgages not been invented, but in most parts of the world stock markets themselves had not yet been invented! But never forget – financial markets are subject to, sometimes dependent upon, and often ruled by, the whims of human nature. Human nature is as timeless as the stories from the Bible, the Torah, the Koran, the I Ching and every other compendium handed down orally until finally set down on leather, papyrus, or paper. And no one has described the follies of humans more cogently than Charles Mackay in 1841.
I believe Extraordinary Popular Delusions and the Madness of Crowds is the best book ever written about market psychology. It includes case histories--long before case histories became a standard teaching tool--of three infamous financial manias.
- Tulip mania was a financial bubble in the 1620s and 1630s in Holland when contract prices for tulip bulbs reached amazingly high levels before collapsing. At the height of tulip mania in February 1637, a single tulip contract sold for more than 10 times the annual income of a skilled craftsman. Then it all fell apart.
- John Law's early 1700s Mississippi Scheme, foisted by a Scottish economist mostly upon his French neighbors, in which the “untold wealth” of “Louisiana” (what the French called America and the Caribbean) was to pay off in no time at all. The excitement was so great that he issued considerably more paper shares than there was money in the Banque Generale Privee, at that time effectively the central bank of France -- which he was head of -- and which was effectively the guarantor of all that paper.
- The South Sea Company was established on the British side of The Channel about the same time. It was granted a monopoly to trade in Spain's Central and South American colonies as part of a treaty after the War of Spanish Succession. In return, the company assumed the entire national debt England had incurred during that war. (Europeans used the term "South Seas" to refer to the waters surrounding South America.) Established by the Lord Treasurer, Robert Harley, what Harley didn’t mention, and apparently no one bothered to ask, was that, as part of the treaty with Spain, the South Sea Company was allowed to send only one trading ship per year to Spain’s American colonies! Still, people in that heavily class-conscious society, from the lowest to the highest, threw money at the venture as the company employed "the most extravagant rumours" to pump the share price from 100 Pounds to 1,000 Pounds in less than a year. All lost except those within the government and the nobles who had never really paid for their shares but were invited to accept shares in exchange for the use of their august names.
But Mackay doesn’t stop with a case study of each of these early manias. The book is part history, part thriller with enough colorful and crazy characters and anecdotes to read more like a novel. And he includes chapters on other “popular delusions” beyond the financial arena, including chapters on alchemy,The Crusades, the witch mania and the European witch trials of the 1400s-1600s, prophecies, fortune-telling, catch phrases & slang, relics, duels & ordeals, haunted houses, & popular admiration of thieves.
If that isn’t enough to whet your interest, let me suggest that you cannot understand the dot-com phenomenon or the real estate bust nearly as readily without studying how it’s all happened before. Remember, nearly $1 and ½ trillion was invested in Internet stocks by some of the savviest investors in the world. When it was all said and done, that trillion and a half had been reduced to less than $100 billion. We all lived through it. But some of us sidestepped it. I attribute that partly to my recollections of readings from this book.
By understanding the patterns of greed and hope, and the ready willingness of charlatans to step forward to give us what we want, we might avoid the pitfalls that inevitably follow. If you understand that, when someone utters the words, “This time it’s different” you are in the end-stages of a popular mania and can extricate yourself, you just might save your entire fortune. I’m guessing that the rank-and-file Enron employees, who sunk their entire life savings into Enron stock, wish they would have done so.
This book is more than a book on intelligent investing – it is really a classic in critical thinking. Anyone can learn how to read a chart or throw bones into a circle, but this book will teach you about human psychology. That is how you beat the market, since it is always a marketplace of humans motivated by fear, greed, hope, arrogance and all the other human emotions, good and ill...
What I take for action from this re-reading of Extraordinary Popular Delusions and the Madness of Crowds is that the “prevailing wisdom” is less about wisdom than it is the prevailing combination of hopes, fears, greed, arrogance, wishes and prayers that enough people fervently want to believe in. And that man is a social animal influenced by others in his social, business, personal, reading or Internet-surfing circle, a circle he defines based upon his own biases, upbringing, prejudices, experience, and the comments and approbation or criticism from those around him.
So, in 1929, many years after Mackay wrote this little gem, that combination of hopes, fears, wishes and prayers that enough people fervently want to believe in led them to believe they were on a permanently high plateau from which companies could never fall. In 2000, the same geist / sentiment prevailed in regards to dot-com companies. It was The New Economy, A New Paradigm, The New Reality. No it wasn’t. Any more than home prices, circa 2006, could never fall in San Francisco, Las Vegas, Miami or wherever the proponent of exponential growth wanted so fervently to believe in.
And in 2010, when all those around me are investing as if there will never be another correction, retrenchment, or minor or major pullback, I am quite comfortable under-performing the market for 10 or 12 weeks and sticking with high dividend-paying equities and bond funds with 1-3 year maximum maturities, while shorting US Treasuries via the ProShares UltraShort 20+ Year Treasury ETF (TBT) or the Direxion Daily 30 YR Treasury Bear 3X (TMV) (Yes, as I always caveat, recognizing the inherent volatility of leveraged and daily-settled ETFs, all well-detailed in previous articles and comments.) For some other income ideas and a volatility play (NYSEARCA:VXX) check here and in numerous previous articles.
Author's Disclosure: We and / or clients for whom these investments are appropriate, are still long NRP, PVR, OTC:ATLIF, NZT, FTE, TBT, TIP, NSL, PFL, TMV and VXX – all with trailing stops, and all while still maintaining a good cash cushion.
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