Keynes and the Market Part 3

-Sir Isaac Newton, PHILOSOPHIAE NATURALIS PRINCIPIA MATHEMATICA In July 1936, only a few months after the release of The General Theory, Keynes acquired at auction a large steel trunk from a . nancially embat-tled English aristocrat.The box contained some of the personal papers of Isaac Newton, Cambridge ' s most famous son. Newton is venerated as a giant of science, the son of an illiterate farmer who ushered the world into the Age of Enlightenment. In the words of Alexander Pope: Nature and Nature ' s laws lay hid in night: G.o.d said, Let Newton be!

and all was light.

In the year 1666 alone - the " Year of Wonders " - the young Newton, locked away at home after the Plague had forced the closure of Cambridge ' s colleges, invented differential calculus, formulated the

Law of Universal Gravitation, and proposed his Theory of Light. He was celebrated as the discoverer of " the grand secret of the whole Machine," a man whose incandescent intelligence snuffed out the shad-ows of medieval superst.i.tion and ignorance.

The High Priest of Reason was, however, something of a heretic behind closed doors. Much of Newton ' s early life was spent in his " elaboratory," where, according to his a.s.sistant, his " chemical exper-iments . . . aimed at something beyond the reach of human art and industry." Newton was no dry geometer of the universe - despite the mechanistic conception of the world he propounded, he was obsessed with alchemy and the supernatural. He never completely accepted the notion of " inanimate brute matter," suspecting instead that life was invigorated by unseen " animal spirits " in the ether.

Newton was also an ardent pursuer of material wealth. Unsuccessful in his alchemical effort to trans.m.u.te base metals into gold, he eventu-ally found his own Philosopher ' s Stone as Master of the Royal Mint. In this capacity, Newton oversaw the recoinage of England ' s currency, receiving a commission on all coins struck under his supervision and becoming extraordinarily rich in the process. In 1720, toward the end of his long life, Newton ventured some of his fortune in stock of the South Sea Company. After selling his initial holding for a considera-ble pro.t, Newton was induced by rising stock prices to re - enter the market. The second time around he was not so lucky. The South Sea Bubble burst and Newton lost around 20,000 - more than $6 million in today ' s money. Chastened by this demonstration of gravity in the world of .nance, he remarked ruefully, " I can calculate the motions of heavenly bodies, but not the madness of people."

Like his hero Newton, Maynard Keynes also learned the hard way that - largely due to the unavoidable fact of uncertainty - . nancial markets were sometimes buffeted by unpredictable squalls of " whim or sentiment or chance " and prey to " purely irrational waves of optimism or depression." Having spent a decade trying to antic.i.p.ate the quicksil-ver tacks of the market - and having been wrong - footed on more than one occasion - Keynes .nally concluded that those who run with the crowd are apt to be trampled. Better to stand back from the thundering herd, he decided, than be torn asunder in the running of the bulls or the .ight from the bears.

The Uncertainty Principle . . . in the greatest part of our Concernment, [G.o.d] has afforded us only the twilight.

-John Locke, AN ESSAY CONCERNING HUMAN UNDERSTANDING Among his other accomplishments, Keynes was also a leading author-ity on Newton, a position enhanced by his acquisition of the scientist ' s papers. Keynes brought to the world ' s attention the occult - obsessed, metaphysical side of Newton - portraying him as a man with " one foot in the Middle Ages, and one foot treading a path for modern sci-ence." He also appropriated Newton ' s idea of " animal spirits " - arguing that in the supposedly mechanistic world of .nancial markets, inves-tors were often propelled by something other than a clinical a.n.a.lysis of expected outcomes.

Keynes ' General Theory explained that .nancial markets are not only p.r.o.ne to periodic informational cascades that compromise ef. ciency, but also that investors cannot be the rational actors of cla.s.sical theory because a cold calculation of expected outcomes is simply not possible. With incontrovertible common sense, Keynes observed that there are some events for which " there is no scienti.c basis on which to form any calcu-lable probability whatever " : The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often neg-ligible. If we speak frankly, we have to admit that our basis of knowl-edge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and some-times to nothing . . .

" Wishes are fathers to thoughts," Keynes once observed. Remark ably, it seemed that in championing the case for ef. cient markets, ortho-dox theory had glossed over the fact that " core risk " - uncertainty that cannot be a.s.signed a probability - precludes a precise calculation of a stock ' s expected yield. Keynes therefore rejected orthodox theory ' s blithe a.s.sumption that, in valuing a security, .nancial market par-tic.i.p.ants could perform " a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appro-priate probability, waiting to be summed." Despite the a.s.sumptions of cla.s.sical theory, there are, as Keynes pointed out, many factors about which " we simply do not know."

My Indecision Is Final Prediction is very dif.cult, especially about the future.

-Niels Bohr (attributed) Keynes invoked a paradox beloved of philosophers - that of " Buridan ' s a.s.s " - to ill.u.s.trate why " the necessity for action and for decision com-pels us as practical men " to overlook the " awkward fact " that a uniquely correct valuation of a stock is impossible. Buridan ' s a.s.s is an apocryphal beast that, faced with two equally attractive and accessible bales of hay, starved while deliberating which one was preferable. Like the donkey of the parable, stock market partic.i.p.ants - if they were to attempt to apply a purely rational approach to their investment decisions - would also be rendered immobile by the daunting " what ifs " of an unknowable future. Instead, they resort to less a.n.a.lytical factors when a.s.sessing stock market opportunities: To avoid being in the position of Buridan ' s a.s.s, we fall back . . . on motives . . . which are not " rational " in the sense of being concerned with the evaluation of consequences, but are decided by habit, instinct, preference, desire, will etc.

The stock market player is impelled - in part at least - by factors that, although not rational, are nevertheless legitimate in some sense. Unlike the situation with, say, government bonds - which pay a . xed coupon, and whose present investment value can be determined with reasonable precision - stocks exist in a twilight zone of ambiguity.This uncertainty gap is a blank canvas on which the investor projects his or her most fervent hopes or darkest fears." Animal spirits " - the " spontaneous urge to action rather than inaction," as Keynes de. ned them - embolden individuals and allow them to bridge the uncertainty gap inherent in any investment decision.

The investor, Keynes concluded, is not the perfectly knowledge-able calculating machine of orthodox theory. Despite the a.s.sertions of ef.cient markets proponents, stock market behavior is not - cannot be- governed by purely rational factors. Investor psychology plays an integral role in the decision to buy, sell, or hold a stock.As Keynes summarized: . . . a large proportion of our positive activities depend on sponta-neous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits . . . and not as the outcome of a weighted average of quant.i.ta-tive bene. ts multiplied by quant.i.tative probabilities.

Jumping at Shadows The stock market has predicted nine out of the last .ve recessions.

-Paul Samuelson, NEWSWEEK Not only does the presence of uncertainty mean that investors fall back on their " state of con. dence " or " animal spirits " when making invest-ment decisions, but it also exaggerates the impact of near - term factors on a stock ' s performance. In his A Treatise on Money, published in 1930, Keynes noted: . . . how sensitive - over - sensitive if you like - to the near future, about which we may think we know a little, even the best - informed must be, because, in truth, we know almost nothing about the more remote future.

Not unreasonably, Keynes conceded, investors attach greater weight to matters about which they are relatively more con. dent, " even though they may be less decisively relevant to the issue than other facts about which our knowledge is vague and scanty." In consequence: . . . the facts of the existing situation enter, in a sense disproportion-ately, into the formation of our long - term expectations; our usual practice being to take the existing situation and to project it into the future, modi.ed only to the extent that we have more or less de. nite reasons for expecting a change.

The broad a.s.sumption that " the existing state of affairs will con-tinue inde. nitely " means that: Day - to - day . uctuations in the pro.ts of existing investments, which are obviously of an ephemeral and non - signi.cant character, tend to have an altogether excessive, and even an absurd, in.uence on the market.

As an example of this tendency, Keynes claimed - not without a touch of hyperbole - that " the shares of American companies which manu-facture ice tend to sell at a higher price in summer when their pro. ts are seasonally high than in winter when no one wants ice " and that the " recurrence of a bank - holiday may raise the market valuation of the British railway system by several million pounds."

The focus on the shorter term means that investor expectations - and therefore stock prices - are extremely sensitive to new information, and that: Faced with the perplexities and uncertainties of the modern world, market values will .uctuate much more widely than will seem rea-sonable in the light of after - events . . .

In simple terms, the unavoidable fact of uncertainty prompts stock market players to latch on to new information, causing stock prices to overshoot. Empirical evidence supports Keynes ' thesis - studies show that stock prices display far greater volatility than would be expected relative to changes in underlying earnings and dividends. Exacerbating this tendency to overweight new information is the " risk averse " nature of the average investor - his or her propensity to feel . nancial losses more keenly than equivalent gains. Risk aversion may cause stock prices to react disproportionately to negative news, as investors overdis-count security prices affected by unfavorable new information.

Con. dence Trick Randolph Duke: Exactly why do you think the price of pork bellies is going to keep going down,William?

Billy Ray Valentine: Okay, pork belly prices have been dropping all morning, which means that everybody is waiting for it to hit rock bottom, so they can buy low.Which means that the people who own the pork belly contracts are saying," Hey, we ' re losing all our d.a.m.n money, and Christmas is around the corner, and I ain ' t gonna have no money to buy my son the G. I. Joe with the kung - fu grip! And my wife ain ' t gonna f - my wife ain ' t gonna make love to me if I got no money! " So they ' re panicking right now, they ' re screaming " SELL! SELL! " to get out before the price keeps drop-ping. They ' re panicking out there right now, I can feel it.

-TRADING PLACES The stock market, Keynes demonstrated, was not always the una.s.sailable paragon of ef.ciency that orthodox .nancial theorists claimed it to be. It was p.r.o.ne to informational cascades - episodes where prices would s...o...b..ll in one direction or the other merely because momentum had seized the market - and, more fundamentally, investment decisions were impelled to some extent by necessarily nonrational factors. As Keynes pointed out, due to the inescapable fact of uncertainty, " all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield."

To take but one example, a biographer of Marcel Proust, that rich but troubled neurasthenic of the early twentieth century, noted that the French author: . . . made many ruinous investments but refused to listen to his banker . . . More often than not he purchased a stock because of its poetic name ( " The Tanganyika Railway," " The Australian Gold Mines " ); in fact, these stocks were a subst.i.tute for the travels to exotic places he longed to make.

Like Tolstoy ' s unhappy families, all irrational investors are irrational in their own particular way. Proust ' s purchases, made in the antiseptic emptiness of his cork - lined bedroom, were guided by the evocativeness of a company name, their words as charged with a.s.sociations as his tea -soaked madeleine biscuits. Other, perhaps less poetically inclined, mar-ket players might equally be in.uenced by a perceived trend in a stock ' s price, an inside tip, or what the chap next door is doing.

Keynes ' view of the stock market was diametrically opposed to that of orthodox .nancial theory, where, as the reference books inform the reader, " investors are unromantically concerned with the . rm' s cash .ows and the portion of those cash .ows to which they are ent.i.tled." In the make - believe world of cla.s.sical theory, the stock market was conceived as an infallible machine for crystallizing the present value of future income from a security. Real world complications such as uncertainty and the state of investor con.dence were conveniently dis-regarded in the interests of theoretical elegance. Orthodox theory did not admit the possibility that the virus of animal spirits could infect the machine, causing it to generate numbers which could depart widely from any reasonable a.s.sessment of true value.

State of Emergency Under certain circ.u.mstances . . . an agglomeration of men presents new characteristics very different from those of the individuals comprising it.

-Gustave Le Bon, THE CROWD Economics has been greatly in.uenced by discoveries in the " hard " sciences - the clockwork precision of Newtonian physics was re. ected in cla.s.sical theory ' s mechanistic conception of the world; Darwin ' s doc-trine of survival of the .ttest inspired the muscular free - trade policies of the Victorian era; and Einstein ' s bizarre theories of relativity were mirrored in the Keynesian universe, where money - like time - was sometimes more than a mere inert cipher. Keynes argued, however, that economics seemed to depart from the comforting resemblance to science in at least one key respect. In the discipline of economics, he a.s.serted," the atomic hypothesis that has worked so splendidly in phys-ics breaks down," and consequently: We are faced at every turn with the problems of organic unity, of dis-creteness, of discontinuity - the whole is not equal to the sum of the parts, comparisons of quant.i.ty fail us, small changes produce large effects, the a.s.sumptions of a uniform and h.o.m.ogeneous continuum are not satis. ed.

The economy, as Keynes noted, exhibits what have come to be called " emergent properties " : complex, sometimes unpredictable, collec-tive behavior in a system, arising out of the multiplicity of interactions between its individual const.i.tuents.

Behavior in the atomistic world of microeconomics cannot always be extrapolated to the sphere of macroeconomics, the study of aggre-gates. Keynes ' most famous example of the " fallacy of composition " was the so - called Paradox of Thrift - which notes that saving is good for the individual, but if all individuals increase their savings then aggregate demand will fall, eventually leading to lower savings for the population as a whole. Similarly, the stock market - one of the purest expressions of the free market system - can, on occasions, display emergent proper-ties, where individual behavior mutates into mob irrationality. Even for someone of Keynes ' protean interests and abilities, the stock market was simply too vast and too complex a mechanism to second - guess.

A Sentimental Education Don ' t try to buy at the bottom and sell at the top.This cannot be done - except by liars.

-Bernard Baruch, MY OWN STORY Keynes eventually concluded that because of the utter capriciousness and complexity of the stock market, a short - term " momentum invest-ing " approach rarely rewarded its followers with .nancial success.As he conceded to a colleague in May 1938: I can only say that I was the princ.i.p.al inventor of credit cycle invest-ment and have seen it tried by . ve different parties acting in detail on distinctly different lines over a period of nearly twenty years, which has been full of ups and downs; and I have not seen a single case of a success having been made of it.

Keynes thought that credit cycling not only demanded " abnormal foresight " and required " phenomenal skill to make much out of it," but that transaction expenses from such a necessarily active investment policy tended to erode trading pro.ts. He expanded on this theme in a memorandum to the King ' s College Estates Committee: . . . I am clear that the idea of wholesale shifts [out of and into stocks at different stages of the business cycle] is for various reasons imprac-ticable and indeed undesirable. Most of those who attempt it sell too late and buy too late, and do both too often, incurring heavy expenses and developing too unsettled and speculative a state of mind . . .

Keynes ' realization that there was no method to the market ' s madness prompted a radical change in his investment approach. Following the Great Crash, he completely inverted his investment principles, becom-ing an investor rather than a speculator - one who focuses on likely future performance rather than past trends, expected yield rather than disposal price, particular stocks rather than the broader index, and rely-ing on his own judgment rather than that of the market. Simply stated, Keynes switched from market timer to value investor, seeking to pro. t from swings in the market rather than partic.i.p.ating in them.

Chapter 7

Game Players

Flowering Inferno " It ' s always best on these occasions to do what the mob do. " " But suppose there are two mobs? " suggested Mr. Snodgra.s.s." Shout with the largest," replied Mr. Pickwick.

-Charles d.i.c.kens, THE PICKWICK PAPERS " Tulipomania " saw the pathogen of animal spirits visit that most stolid of people, the Dutch burghers of the seventeenth century. As Charles Mackay recalls in his catalog of human folly, Extraordinary Popular Delusions and the Madness of Crowds, the " rage to possess " tulips was so powerful that: n.o.bles, citizens, farmers, mechanics, seamen, footmen, maidser-vants, even chimney - sweeps and old clotheswomen, dabbled in tulips. People of all grades converted their property in cash, and invested it in . owers.

Speculative fervor for the exotic plants was such that traders, in an early version of a futures contract, started to sell the rights to bulbs they had not yet even planted.This innovation - dismissively labeled windhandel, or " wind trade," by those untouched by the mania - encouraged even more speculation, as trading moved from the physical to the abstract.

" Broken " . owers- cultivars with .ares of blazing color - were the most highly valued. By early 1637, one bulb of the Semper Augustus strain - its blood - red .ames vivid against a pure white - commanded the same price as a large ca.n.a.l - side house in Amsterdam. The varie-gated hues of these prized .owers were caused by a virus, and, as was later discovered, it was the virus that both increased the attractiveness of the .owers and also contributed to their frailty.As Mackay explained: When it has been weakened by cultivation, [the tulip] becomes more agreeable in the eyes of the .orist . . . Thus this masterpiece of cul-ture, the more beautiful it turns, grows so much the weaker, so that, with the greatest skill and most careful attention, it can scarcely be transplanted, or even kept alive.

The Dutch tulipomania eventually, and inevitably, unwound in a most spectacular manner. Bulbs that had sold for 5,000 guilders in January 1637 fetched only 50 guilders a month later. The Dutch courts correctly diagnosed the malady that had temporarily seized the population - characterizing the transactions as nothing more than gam-bling operations, they declined to enforce outstanding contracts of sale.

The tulipomania - in addition to providing another ill.u.s.tration of the periodic irrationality that ensnares markets - also affords a meta-phor for .nancial exchanges generally. Like the tulip, whose re. nement and frailty move in tandem, the more highly evolved a stock market, the greater the risk that it will be susceptible to the contagion of ani-mal spirits.As Keynes noted in The General Theory, when " the organiza-tion of investment markets improves, the risk of the predominance of speculation does, however, increase."

Having disposed of the .ction of investors as rational calculating machines summing risk - weighted expected cash .ows, Keynes then pro-ceeded in The General Theory to identify other factors, largely attributable to the increasing sophistication of .nancial exchanges, that he believed compromised the ef.ciency of markets.When discriminating investors are " so much in the minority that their behavior does not govern the market," Keynes argued, a stock exchange could a.s.sume the traits of its " game players," evincing an excessively short - term approach and presenting with bipolar tendencies.

The Dangers of Democracy I don ' t want to belong to any club that will accept me as a member.

-Groucho Marx, GROUCHO AND ME Keynes, unapologetic elitist that he was, believed that the increasing democratization of stock investing adversely affected the stability of the system.As he observed in The General Theory: That the sins of the London Stock Exchange are less than those of Wall Street may be due, not so much to differences in national char-acter, as to the fact that to the average Englishman Throgmorton Street is, compared with Wall Street to the average American, inac-cessible and very expensive.

Keynes thought that " liquid " . nancial exchanges - those with low transaction costs and that are effectively open to all - encouraged the entry of dilettante investors who " have no special knowledge of the cir-c.u.mstances, either actual or prospective, of the business in question."

He believed that the lack of real knowledge about the underly-ing business increased the stock market ' s .ckleness and its propensity to overreact to new information," since there will be no strong roots of conviction to hold [a valuation] steady." Keynes also lamented that the . nancial exchanges - with their constant price quotations and potential to readily monetize investments - gave: . . . a frequent opportunity to the individual . . . to revise his com-mitments. It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming busi-ness between 10 and 11 in the morning and reconsider whether he should return to it later in the week.

Greater liquidity, lower transaction costs, and the advent of the Internet combine to make shares even easier to trade today, and in consequence have further exacerbated the .ightiness of capital. These factors also make stocks increasingly abstract concepts, disembodied from the busi-nesses they represent - " an abstraction, a name, a symbol interchange-able with a certain amount of money," as one commentator described the transformation of the humble tulip during the Dutch derangement of the seventeenth century. The perception by many market partic.i.p.ants that stocks are little more than a number in a newspaper column or on a computer screen- a mere trading chip divorced from the underly-ing business, rather than a part - interest in the business itself - further in.ames the speculative mindset.

Outrunning the Bear Worldly wisdom teaches that it is better for reputation to fail conven tionally than to succeed unconventionally.

-Keynes, THE GENERAL THEORY The story is told of two hunters, madly scrambling through a forest, try-ing to evade a particularly cantankerous and agile bear. Mid - pursuit, one stops, reaches into his backpack, and changes into running shoes. The other man tells him he is crazy - there is no way he will be able to out-run the bear, even with his new footwear. " I don ' t need to outrun the bear," he replies," I just need to outrun you. " A similar dynamic exists on modern stock markets, where fund managers and other . nancial insti-tutions are largely a.s.sessed on performance relative to their peers over short intervals, rather than by reference to their absolute investment performance over the longer term. This benchmarking practice natu-rally encourages fund managers to adopt a near - term focus - for even if the inst.i.tutions themselves are impervious to the siren calls of the mob, their unit - holders may not possess the same forbearance.

The ef.cient markets hypothesis states that although some stock market partic.i.p.ants may not boast Spock - like levels of rationality and cool - headedness, the smart money will nevertheless act to rein in any pricing anomalies produced. Keynes dismissed this belief as little more than a convenient . ction: It might have been supposed that compet.i.tion between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long - term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the con-ventional basis of valuation a short time ahead of the general public.

Professional investors, in practice, rarely accept the role of market monitor a.s.signed to them by orthodox theory. As Keynes noted, there is overwhelming inst.i.tutional pressure to conform, even among alleg-edly sophisticated investors: . . . it is the long - term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is suc-cessful, that will only con.rm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.

Like the ma.s.s of investors, fund managers are more often concerned with not underperforming than trying to outperform. In practice, they do not provide a countervailing force against the more . ighty investors - indeed, on many occasions they actually amplify the swings of investor irrationality.

Intensifying the short - term focus of many inst.i.tutional investment managers are two additional factors - an emphasis on " total returns " as a performance guide, and the presence of " index - tracking funds." Total returns measures - comprising dividend payments and any increase or decrease in the price of a given stock - are usually dominated by unreal-ized capital gains or losses, which once again focuses attention on short -term stock price . uctuations. Index - tracking funds - investment vehicles that seek to replicate market performance by holding a representative portfolio of stocks - aggravate the market ' s tendency to overshoot by reinforcing trends in the market. Index funds are momentum investors in excelsis- they automatically buy more of a stock as its price, and therefore its value relative to the broader market, increases, and sell as its price decreases - thus adding to overshoots and further eroding the purported ef. ciency of . nancial exchanges.

Bipolar Bears (and Bulls) [Bipolar Affective Disorder] is . . . characterized by repeated . . . episodes in which . . . mood and activity levels are signi.cantly dis-turbed, this disturbance consisting on some occasions of an elevation of mood and increased energy and activity (mania . . .), and on others of a lowering of mood and decreased energy and activity (depression). Characteristically, recovery is usually complete between episodes . . .

-CLa.s.sIFICATION OF MENTAL AND BEHAVIOURAL DISORDERS,World Health Organization The stock market, Keynes showed, could move violently in response to changes in investor psychology, was susceptible to informational cascades, could overshoot based on new information, was excessively focused on near - term price performance, and was populated by inves-tors having " no special knowledge " of the stocks in which they trade. One .nancial markets pract.i.tioner who shared Keynes ' rather jaundiced view was Benjamin Graham, an American investor and academic. Like Keynes, Graham had been badly burnt by the Great Crash, his stock portfolio losing almost three - quarters of its value during the slump. And again like Keynes, this loss - combined with observations picked up while working on Wall Street - motivated Graham to think deeply about . nancial exchanges and their frailties.

Graham believed that stock markets were periodically in. uenced by pendulum swings of investor sentiment, when quoted prices depart signi.cantly from a stock ' s underlying value, and that these swings could be exploited by the rational, patient investor: . . . price .uctuations have only one signi.cant meaning for the true investor.They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.

To ill.u.s.trate his thesis, Ben Graham proposed a novel way to think about the stock market. He encouraged investors to imagine that they are dealing with an individual who, each trading day, offers to buy or sell stocks at a given price.As Graham explained," Mr. Market " : . . . is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest on that basis.

Mr. Market is often a relatively stable and rational ent.i.ty, offering to deal in stocks at prices which approximate their true worth. Sometimes, how-ever, Mr. Market lapses into mania or depression, is panicked by a negative piece of news or elated by apparently positive developments, or focuses excessively on short - term factors while missing the bigger picture.When Mr. Market " lets his enthusiasm or his fears run away with him ," Graham observed," the value he proposes seems to you a little short of silly."

The stock market, Graham implied, could sometimes be neurotic, paranoid, myopic, and af.icted by mania or depression - if it were an individual, it would be medicated.Yet despite all his pathologies and char-acter .aws, Mr. Market possesses one sterling virtue - that of perseverance. He is not offended if an investor is unresponsive to his constant solicita-tions, and will unfailingly return every trading day with renewed offers to buy and sell securities. Using Mr. Market as an investment adviser, Graham cautioned, could be ruinous for an investor. On the other hand, the poor fellow could be exploited when he was in the throes of an irra-tional episode - for although Mr. Market frequently degenerated into a form of madness, he would eventually come to his senses, and stock prices would in due course revert toward their fundamental value.

Buffy the Empire Slayer Charlie Munger: If you mix raisins with t.u.r.ds, they ' re still t.u.r.ds.

Warren Buffett: That ' s why they have me write the annual report.

-Berkshire Hathaway annual meeting, 2000 Ben Graham ' s investment company sp.a.w.ned a number of highly successful value investors, the most famous of whom is Warren Buffett.

Buffett is one of the world ' s richest men, but unlike most other mem-bers of the billionaires ' club, his wealth was built entirely from stock market and other company investments. As Time magazine noted in a pro. le on Buffett: We' ve seen oil magnates, real estate moguls, shippers, and robber bar ons at the top of the money heap, but Buffett is the . rst person to get there just by picking stocks.

Buffett has been investing for over half a century, and his record is remarkable. In the four decades or so since he acquired Berkshire Hathaway as his investment vehicle, the company has outperformed the broader market by a . fty fold margin.This investment performance represents an average compounded return of more than 20 percent a year - a record unmatched by any other large, long - term investor.

Buffett and his vice chairman at Berkshire Hathaway, Charles Munger, are the Butch Ca.s.sidy and Sundance Kid of the investment world. Buffett is a wisecracking, c.o.ke - swigging septuagenarian dis-pensing pithy .nancial wisdom in perfectly honed epigrams, while the octogenarian Munger revels in the role of straight man and resi-dent curmudgeon. In his letters to stockholders and at Berkshire Hathaway' s annual meetings - labeled " Woodstock for Capitalists " by the Chairman - Buffett plays up the image of himself as a gauche but deceptively wise Midwesterner, possessed of deep reserves of folksy common sense. The phlegmatic Buffett is the ant.i.thesis of the edgy, volatile stock market players depicted in popular culture, and there is a satisfying moral resonance to his message - the meek and un. ashy may indeed inherit the earth.

Warren Buffett is not the " Wizard of Wall Street " or the " Sage of Silicon Valley," but rather the " Oracle of Omaha." Berkshire Hathaway is headquartered in Omaha, Nebraska - about equidistant from Wall Street and Silicon Valley, as if reluctant to get too close to either. The positioning seems uncannily appropriate. The Berkshire Hathaway duo dismiss many of the maxims of conventional .nance, and their consistent outperformance of the broader indices is a living reproof to the ef.cient markets hypothesis. They are proud Luddites, famous abstainers during the dot - com delirium, and merciless critics of the hyperactivity of day traders and some investment funds. In a feat of exquisite symmetry - and as if to underline Buffett ' s contrarian invest-ment style and his absolute antipathy to the .nancial fads that periodi-cally hijack the market - during the rollicking dot - com days of early 2000, Berkshire Hathaway stock fell to a three - year low on the same day the NASDAQ reached its record high.

Buffett owes much of his success to Ben Graham ' s insights on stock market behavior. He has embraced Graham ' s Mr. Market a.n.a.logy - frequently referring to the " various forms of ma.s.s hysteria that infect the investment markets from time to time " - and has also wholeheart-edly adopted some of Graham ' s other principles, such as ensuring that a signi. cant " margin of safety " exists when purchasing securities. But in many ways Buffett ' s stock market philosophy is far closer to that practiced by Keynes decades earlier. Noting that Keynes " began as a market - timer . . . and converted, after much thought, to value invest-ing," Buffett often cites his philosophical fellow traveler when musing on the stock market.

Far From the Madding Crowd When the facts change, I change my mind - what do you do, sir?

-Keynes (attributed) Keynes ' break with credit cycling marked his transformation from spec-ulator to investor. He de.ned speculation as " the activity of forecasting the psychology of the market," in contrast to " enterprise," or true invest-ment, which involves " forecasting the prospective yield of a.s.sets over their whole life." The investor focuses on the income that a security is expected to produce, not the possible sale price of that security in the near term. Or, to employ Keynes ' terminology, the true investor is con-cerned more with " ultimate values " than " exchange values."

Rather than trying to be a type of market barometer - gauging whether fair winds or foul would visit the exchange - Keynes decided to take advantage of the stock market ' s " bull tacks " and " bear tacks " in another way. He would no longer attempt to time, or antic.i.p.ate, general movements in the market; instead, he would use the value of a particular stock as his investment guide. Only when the pendulum of investor sentiment had swung too far in respect of a given stock - such that the quoted price veered signi.cantly from a.s.sessed fundamental value - would Keynes consider buying or selling that security.

As Keynes summarized, this alternative investment policy: . . . a.s.sumes the ability to pick specialties which have, on the average, prospects of rising enormously more than an index of market lead-ers . . . this practice does, in my opinion, in fact enable one to take at least as good an advantage of .uctuations as credit cycling, though in a rather different way. It is largely the .uctuations which throw up the bargains and the uncertainty due to .uctuations which prevents other people from taking advantage of them.

Keynes realized that the distance from manic to panic on the stock market could be vanishingly short. Rather than trying to outwit the mercurial mob and antic.i.p.ate in.ections in the investment cycle, he concluded it was far more preferable to pick the low - hanging fruit that occasionally presented itself to the investor.

The Prodigal Son There are two times in a man ' s life when he should not speculate: when he can ' t afford it, and when he can.

-Mark Twain, PUDD'NHEAD WILSON'S NEW CALENDAR Keynes ' switch from speculator to value investor delivered a radical change in his fortunes. In contrast to the grim days of the early 1930s - where, " although not quite dest.i.tute," he had been obliged to put two of his best - loved paintings, a Matisse and a Seurat, up for sale - Keynes had again become " horribly prosperous " by the time The General Theory was published. In the years between the Wall Street Crash and the end of 1936, Keynes multiplied his wealth more than sixty fold, parlaying net a.s.sets of just under 8,000 at the end of 1929 to more than 500,000 only six years later.

Just as impressive as his .nancial recovery was his return to the Establishment fold.The man who had likened himself to Ca.s.sandra of Greek mythology - gifted with the powers of prophecy, but fated never to be believed - found himself embraced once again by the ruling elite. Like Churchill, Keynes was drafted into deal with a situation he had long presaged, when in 1940 he became an unpaid adviser to the Chancellor - in his words, a " demi - semi - of. cial " with a wide - ranging brief to formulate economic policy for war - pressed Britain. The fol-lowing year he was installed as a director of the Bank of England - on his appointment he quipped to his mother that it could only be a matter of time before he became a bishop - and in 1942 elevated to a peerage, becoming Lord Keynes, Baron of Tilton. In the closing stages of the war he continued to straddle the worlds of Mammon and of Art - acting as Britain ' s chief representative at both the international monetary conference at Bretton Woods and in loan negotiations with the United States, and becoming the United Kingdom's .rst arts tsar as inaugural chairman of what would evolve into the British Arts Council.

Remarkably, these various of. ces were carried out while Keynes was in extremely frail health. In mid - 1937, just before his . fty - fourth birth-day, he suffered his .rst heart attack, and was con.ned to a sanatorium and later his country house in Suss.e.x for much of his convalescence. Paralleling Keynes ' physical breakdown was a short, sharp economic recession in late 1937 and 1938, accompanied by another severe " sinking spell " on major stock markets. Unable to attend many board and invest-ment committee meetings due to his enforced con. nement, and obliged to defend his stock market techniques amid yet another bout of perva-sive pessimism, Keynes explained his investment philosophy in a series of letters and memoranda to his colleagues.

It is from this rich doc.u.mentary legacy that we distill Keynes ' six key investment principles, representing a straightforward and time -tested system for exploiting the periodic irrationality of stock markets.