Wednesday, March 7, 2012

Buffett: Three Chapters Investors Should Read - Part II

Below are some excerpts from The General Theory of Employment, Interest, and Money by John Maynard Keynes. This is a follow up to yesterday's post on the three chapters* that Warren Buffett has often said investors should read.

To keep the original post from getting too long, I provided only excerpts from chapter 8 and 20 of The Intelligent Investor.

So now here's a couple of excerpts from chapter 12 of The General Theory of Employment, Interest, and Money:

General Theory of Employment, Interest, and Money - Chapter 12
"In former times, when enterprises were mainly owned by those who undertook them or by their friends and associates, investment depended on a sufficient supply of individuals of sanguine temperament and constructive impulses who embarked on business as a way of life, not really relying on a precise calculation of prospective profit. The affair was partly a lottery, though with the ultimate result largely governed by whether the abilities and character of the managers were above or below the average. Some would fail and some would succeed. But even after the event no one would know whether the average results in terms of the sums invested had exceeded, equalled or fallen short of the prevailing rate of interest; though, if we exclude the exploitation of natural resources and monopolies, it is probable that the actual average results of investments, even during periods of progress and prosperity, have disappointed the hopes which prompted them. Business men play a mixed game of skill and chance, the average results of which to the players are not known by those who take a hand. 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.

Decisions to invest in private business of the old-fashioned type were, however, decisions largely irrevocable, not only for the community as a whole, but also for the individual. With the separation between ownership and management which prevails to-day and with the development of organised investment markets, a new factor of great importance has entered in, which sometimes facilitates investment but sometimes adds greatly to the instability of the system. In the absence of security markets, there is no object in frequently attempting to revalue an investment to which we are committed. But the Stock Exchange revalues many investments every day and the revaluations give a frequent opportunity to the individual (though not to the community as a whole) to revise his commitments. 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 11 in the morning and reconsider whether he should return to it later in the week."

The convenience and low cost of trading makes it easier than ever to own shares of a business. I mean, could it be more straightforward to gain partial ownership of a good business than via the stock market?

This convenience has huge benefits, of course, but also potentially leads to instability when taken to extremes.

Keynes understood, though it was a very different time, that this creates a dilemma.

Speculative excesses, and the instability that comes with those excesses,are inevitable when markets are extremely liquid. So it may be tempting to try and...

"...force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment. For the fact that each individual investor flatters himself that his commitment is 'liquid' (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual." 

It's a problem that we clearly are still struggling with to this day.  Throttling speculative tendencies doesn't come without costs. Getting the right balance, not easy. I wonder if Keynes could imagine speculation would go the extremes we see today.

Obviously, what happened in 1929 obviously wasn't far from the mind of John Maynard Keynes when he wrote the above.


* Those three chapters are 8 and 20 of The Intelligent Investor (Benjamin Graham, 1949) and chapter 12 of The General Theory of Employment, Interest, and Money (John Maynard Keynes, 1936).
-Chapter 8 in Graham's The Intelligent Investor is "The Investor and Market Fluctuations." 
-Chapter 20 in Graham's The Intelligent Investor is "Margin of Safety as the Central Concept of Investment." -Chapter 12 in Keynes' General Theory is "The State of Long-Term Expectation."
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