Monday, July 25, 2011

Buffett on Gambling and Speculation

In this earlier post, Warren Buffett explained how he differentiates investing from speculating. Buffett made a further destinction between gambling and speculating in front of the Financial Crisis Inquiry Commission. Here's the way he explained it:

"I wrote a letter in 1982 to Congressman Dingell, giving my views when they were introducing the S&P index future.

And I said there are legitimate uses for hedging out the long positions and so on. But I said, overwhelmingly, it's going to become a gambling vehicle.

And I would distinguish between speculative and gambling. Gambling involves, in my view, the creation of a risk where no risk need be created.

Now, obviously, if you plant a crop in the spring and you're going to harvest in the fall, you are speculating on what prices are going to be in the fall for your corn or oats or whatever it may be. And you may lay that off on some other speculator.

But that's a risk that the system has to take. You can't grow it in one day. But when you start wagering on — well, on stock index futures, I think that gambling instincts are very strong in humans." - Warren Buffett speaking to the Financial Crisis Inquiry Commission

It's worth noting that, with all participants considered, investing need not be a zero-sum game. In contrast, the very nature of gambling can be no better than zero-sum while speculation, in aggregate, adds nothing but incremental and often unnecessary frictional costs.** Investing, gambling, and speculation may seem similar but only if they are defined rather imprecisely. Well, it seems the latter two things are now swamping the former in the current market environment. This may not be as destructive as ideas like the efficient market hypothesis or the theory of rational expectations*, but I'm of a view that the system is weaker than it would otherwise be because of the sheer quantity of speculation and gambling now going on. As a result, the system in its current form is less capable of performing its essential functions.

"When the price of a stock can be influenced by a 'herd' on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical." - Warren Buffett in the Superinvestors of Graham-and-Doddsville

Financial markets have been and will likely always be rather manic and depressive in nature. It's hardly a new problem. Mood swings in markets will, almost certainly, continue to produce substantially mispriced marketable securities from time to time.

"The market is a psychotic, drunk, manic-depressive selling 4,000 companies every day. In one year, the high will double the low. These businesses are no more volatile than a farm or an apartment block [whose values do not swing so wildly]." - Warren Buffett at Wharton***

The fact is market participants, at times, move in herds in a way that takes price action to extremes. In any case, they're certainly not always the coldly calculated types some seem to imagine.

"I have not been a great fan of the theory of rational expectations – the belief in cold, rational, calculating homo sapiens; indeed, I believe it to be the greatest-ever failure of economic theory, which goes a long way toward explaining how completely useless economists were at warning us of the approaching crisis (with a half handful of honorable exceptions)." - Jeremy Grantham in his Finance Goes Rogue Essay

I just think modern financial markets have developed in a way that, if anything, unnecessarily amplifies this nature.

The holding period for stocks is at an all-time low (for the first time measured in just a few months after being measured in multiple years for most of the past century).

So there are more short-term oriented participants than ever, fewer owners.

We benefit from a system that as often as possible produces market prices approximating the discounted value of what assets can produce over its given life. To me, that begins with having more market participants grounded first and foremost by the intrinsic value of underlying assets and fewer making short-term bets. There's certainly nothing inherently wrong with speculation (in fact, having a certain amount of short-term oriented participation is vital) but, as in pretty much any healthy system, proportion matters.

There will always be certain assets where it's challenging to estimate value. For example, new business startups in highly dynamic industries. Those sorts of assets will naturally have a whole range of possible values. Well, there will inevitably be speculative bets on who the winners and losers are likely going to be and it's hard to see why or how it would be desirable to reign that sort of thing in.

Yet, the mispricing of assets for extended periods of time leads to the misallocation of capital and other resources. Ultimately, that likely throttles potential wealth creation. It sure seem that modifying incentives and some other wise changes to encourage more long-term investing and less speculation (and especially pure gambling) makes sense. Maybe there'd be fewer and less extreme mispricing in the capital markets. That would be a good thing from an overall system perspective (even if it makes life more difficult for individual investors who attempt to profit from mispriced marketable securities).

Basically, less short-termism seems in order. Something both Warren Buffett and John Bogle have called for formally in recent years. In this statement, signed by both of them along with 26 others, they recommended changes to the system that would encourage market participants to take more of  a long view.

Gambling, even when frictional costs are ignored, is no better than a zero-sum game.

Speculation isn't, at least in aggregate, much the same.

Investment need not be.

* Charlie Munger, in November of 2000, talked about efficient markets and the theory of rational expectations: "The possibility that stock value in aggregate can become irrationally high is contrary to the hard-form 'efficient market' theory that many of you once learned as gospel from your mistaken professors of yore. Your mistaken professors were too much influenced by 'rational man' models of human behavior from economics and too little by 'foolish man' models from psychology and real-world experience."
** Ultimately, the returns for market participants as a whole is dictated by what the underlying assets produce over the long haul minus all the frictional costs. So speculation in total adds nothing and, once all costs are considered, actually subtracts from returns. Gambling is also less than zero-sum whenever frictional costs exist.
*** Based upon notes that were taken at a 2006 Wharton meeting.
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