From this conversation with Charlie Munger at Harvard-Westlake:
"Alan Greenspan at the Federal Reserve overdosed on Ayn Rand. Basically he kind of thought anything that happened in the free market, even if it was an axe murder, had to be ok. He's a smart man and [a] good man, but he got it wrong. Generally, an over-belief in any one ideology is going to do you in if you extrapolate it too hard, and that's what happened in economics."
So, according to Munger, what caused this "cognitive failure" in economics?
"They reasoned correctly that a free market would be way more predictive than anything else, and they reasoned correctly that once you had a fairly advanced capitalist system – if the people that were putting up the capital could sell their pieces of ownership in the company to other people, they'd be more inclined to invest because it gave them an option to get out if they wanted to leave. It's not like buying a restaurant in the wrong place. Then they reasoned that if that was true, if you had a really free, liquid, wonderful market in securities, that would be wonderful, and the bigger and more wonderful it was, the better it was for the wider civilization."
Having a million shares trade in a day was a rare occurrence when Munger attended Harvard Law School. Now billions of shares trade each day. He guesses that those who think along these lines are probably looking forward to when trillions of shares will trade in a day. Munger then adds...
"Our civilization is not going to work better if we have trillions of shares traded everyday. It's the most asinine idea you could ever have to extrapolate so vigorously, and of course three or four billion shares is way too many. We have computer programs that are trading with other computer programs. We have many of the bright people who ought to be doing our engineering going to work at hedge funds and investment banks and algorithmic trading places and so on and so on."
Munger goes on to say "at any rate, these people got the idea [that] unlimited trading is a big plus for civilization."
Well, John Maynard Keynes certainly thought otherwise as Munger further explains:
"[Keynes] said a liquid market of securities is one of the most attractive gambling devices ever created. It has all the joy of gambling, plus it's respectable. Furthermore, instead of being a zero-sum game, where you are bound to lose the frictional cost, it's a game where you can pay the frictional cost and actually make a profit. This is one of the most seductive gambling devices ever invented by man, and some nut who took economics thinks that the bigger and better it gets, the better it is for wider civilization."
Now, consider that speaking to Forbes back in 1974, Warren Buffett described the business of investing in the following manner:
"I call investing the greatest business in the world...because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There's no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it."
Investing can certainly be a great business but all this hyperactivity is directly at odds with the reasons why.
Compared to all this rapid trading of price action, waiting patiently for something you understand to get cheap enough, then owning it for a very long time, is a completely different game.
Modern capital markets are an incredibly convenient way to buy part of a good business that's priced attractively with minimal frictional costs.
To me, it seems quite the shame to see something so incredibly useful and powerful converted into a casino; see it turned into something less than it otherwise might be.*
So more of something doesn't automatically make it better. There's often optimal amount -- at least within some range -- and, of course, diminishing returns or worse. Some short-term oriented speculative activity is necessary and even desirable. That doesn't logically mean that unlimited amounts of it is a good thing.
The amount of speculation relative to investment matters and the former is currently swamping the latter. What John Bogle describes as The Triumph of Speculation over Investment.
There may not be a precisely knowable correct ratio of speculation to investment, but I think it's safe to say we are far from what makes sense. I've used the petrol engine as a simple -- even if a limited and imperfect one -- example of this.
The petrol engine just doesn't function all that well if the air-fuel ratio strays too far from what's optimal (and, eventually, it won't function at all if there's too much of either substance).
As with most any system, even what is a comparably simple one, the proportion matters rather a lot.
If efficiently and effectively allocating capital and strong long-term business performance are the primary goals then, in their current hyperactive form, the equity markets seem likely to have far from the optimal ratio of speculation relative to investment.
Check out the entire conversation with Charlie Munger at Harvard-Westlake.
Lots of useful thoughts and insights.
That 1974 Forbes article is a pretty worthwhile read too even if not exactly breaking news.
* Capital markets exist to move funds to where they're needed efficiently, to make sure owners of public companies have some reasonable visibility into how well what they own is being managed for the long haul so they can act accordingly, with frictional costs no higher than necessary. It's not a casino that exists to mostly serve the active participants themselves.
Charlie Munger at Harvard-Westlake