Thursday, August 04, 2005

Relive The Past

Santayana said, “Those who don’t learn from the past are condemned to repeat it”

As an individual, one should strive towards improving his life. This improvement can be brought about by ‘learning’. Each one us should remember his parents say “learn from your mistakes” or in other words “reason out your failures”. It is easier said than done because we all have, to varying magnitude, an ego or bad temperament, which makes it harder for us to rationalize our own irrationalities.

As an investor, we should change that advice to “learn from other people’s mistakes”. The reason is quite simple. Tuitions in stock market does not come cheap. One of the most commonly committed mistake and without doubt the most costly of them is ‘speculation’. I define speculation as “making buy or sell decisions based on 3 Illusions – Hope, Greed or Fear”. This illusion makes one seek value from the prices rather than underlying business. This is in contradiction to the very purpose of owning a share, which implicitly means, “Share in the underlying business”.

Warren Buffett has said, “Only when you combine sound intellectual framework with emotional discipline, you get a rational behavior”.

Keeping oneself away from the ‘speculative drive’ is the most important discipline one needs to develop. I feel that to keep away from such a strong drive, one needs to understand the causes and implications of speculation.

Thus I wish to take a ‘random walk’ into the circumstances of a major and fantastic ‘speculative episode’ of 17th century.

In 1562, I left Constantinople for Amsterdam. I took with me the best tulip I can found. When I landed in Amsterdam, the beauty of tulip made a few people at port question me about it. I, out of my love for the flower, talked in its appreciation and basic utilities of the flower. A guy offered me $1 for the flower. As a visitor, I let him have that tulip as a sign of thanksgiving.

I went into a deep slumber and got up in 1635. (Ya…I do need a lot of sleep. I was born with a sedative in my mouth). The headlines of the newspaper read, “Happy times lay ahead – for everybody”. I got into the illusion street down below; I was amazed to see a tulip in display. But I was more amazed to see that it had a starting bid price of $2000. And I was shocked as to why so many people were bidding for the tulip. I thought of myself as dreaming and pinched myself. Oh… it was for real.

I had not even digested what I had seen by the time I entered Delusion Street. I saw people lending their houses in exchange for tulips. Whenever I stopped to ask what made tulip so attractive. They unanimously replied, “We all ought to be rich”. In their search for the next intellectually vulnerable buyer, a few even asked me “If you need to be rich – then buy a tulip from me at $2500”. Though I had no intention of buying it, I told them that in the illusion street it was selling for $2000. He instead replied, “This is what I mean when I say everybody ought to be rich”. Seeing that everybody was happy and certain about the uncertain future, all I could do was recall what Bagehot has said
“All people are most credulous when they are most exuberant”

Reminding myself that tulip as such had no inherent value to claim such a price and trying to convince myself that I was not making a fool of myself by bucking the trend, I entered Peak Street. There I overheard a politician who, out of his exuberance, was saying, “Once we open up our market for foreigners, they will pay anything for tulip”. I could not help myself but say “I am a foreigner and I don’t think that ill even pay $10”. He laughed at me and advised me “you better learn to change to newer times”.

I reminded myself “Much bad advise is given for free” and ventured into Bang Street. I saw a man crushing a tulip under his feet and shouting “I lend my wife for this tulip to be able buy her a house after selling it for a profit. But nobody wants to even buy it”. (May be he could not find a bigger fool or a more optimistic person than himself)

Just when I was thinking that what could drive the prices so high. I heard a mob following me and throwing stones at me. I heard them shouting “This is Mr. Tulipomania. The guy who brought tulip into our once sacred land”. I wish I could have told them one sentence before being made the scapegoat, “Reason out your mistakes”.

Key Takeaways:

Ø Mass illusion is a common feature during the course of any speculative episode. Before Great Crash, 1929 Irving Fischer of Yale University said, “Stocks have reached a higher plateau and only way forward is up”

Ø Leverage provides the needed fuel to keep the fire going. During 1929, margin calls required only 10% of the underlying value and this is heaven for the speculation hungry people.

Ø Intellectually vulnerable buyer accepted anything for value when it had a chance of doubling next week or month. In 2000, people were buying into stocks at P/E of 600. Ø Everybody wants to be rich believing that they deserve to be rich. They mistake their initial success for skills and start betting heavily until reality hits hard on the face.

Ø Influential people: They are the ones who lead the herd. They don’t dare to buck the trend because of the fear of being called obsolete and insulted. Fidelity’s fund manager Jeremy Vinik was fired for bucking the trend in 1996. He was proved right in 2000 but he had to face insults for 4 years and I don’t think he will ever again buck the trend.

Ø Just before the crash the leveraged position reach their highest levels.

Ø In the aftermath of crash, the angry people set onto find the culprit. And there starts their blame game, which includes everything but speculations.

This is generally what has happened in all the major speculative episodes of the last 3 centuries. Just the main elements are every time disguised in to a newer version. Until and unless people realize that ‘Speculation’ and their ‘emotional indiscipline’ are the culprit, this will happen every now and then. During such periods, for the people who manage to sit tight, it is time to thank our ‘Reasonable historians’.

I think we shall all remember Ben Graham’s immortal words in ‘The Intelligent Investor’

“In the short run, stock market is a voting machine and in the long run it is a weighing machine”.


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