John Kenneth Galbraith, in A Short History of Financial Euphoria, condensed a speculative mania into three parts.

1. New innovation. Something new, financial or technological, captures people’s attention. It’s not new innovation alone. It’s that, gradually, more and more money concentrates into the assets behind that new thing.
2. Debt. The returns on those assets are so good that people want to accelerate their wealth. They turn to leverage, margin loans, derivatives, anything that could enhance returns further.
3. The Crash. Liquidity dries up. Asset prices freefall. Margin calls are made. Forced selling occurs. The new innovation assets are scrutinized too late for many. Painful losses are widespread.

Galbraith’s speculative mania also describes how investors blow up their portfolio. A paper titled, How to Lose Money in Derivatives, studied previous hedge fund blow ups and backs that up.

Quote for the Week

When I shifted my focus from beating gambling games to analyzing the stock market, I naively thought that I was leaving a world where cheating at cards was then problematic and entering an arena where regulation and the rule of law gave investors a fair playing field. Instead, I learned that bigger stakes attracted bigger thieves. Madoff’s Ponzi scheme was only the largest of the many that were exposed in 2008 and 2009, with others ranging from eight billion (a “bank”) through hundreds of millions (including several hedge funds), to multimillion dollar real estate, mortgage and annuity scams. I speculate that the size of swindles likely follows a simple mathematical “power law,” like the distribution of high incomes and top wealth discussed in previous columns, with their number increasing as their economic size decreases…

The flood of almost daily frauds, swindles and hoaxes reported in the financial press has continued during my entire investment career and I expect that when you read this months, years or decades later, you’ll find your own profusion of examples. Hoaxes, frauds, manias and other large scale financial irrationalities have been with us from the beginnings of the markets in the seventeenth century, long before the Internet. — Ed Thorp (source)

Quote for the Week

In a fascinating paper published in 1989, Benjamin Friedman and David Laibson hypothesize that all investors function with two models in mind. The first model approximates the efficient market notion that prices are so close to true value that a movement up is as likely as a movement down and that those movements will be lognormally distributed. The second model is that all hell could break loose at any moment.

Many years ago, an older partner taught me to distinguish between outcomes that are unlikely and outcomes that are catastrophic. The latter are to be avoided even if the odds on them are tiny. Rational investors respond to this type of problem by operating with anchors to windward. They diversify and avoid total commitment to any one bet. But the fear we all share — that what looks like a market today just might not be there for us tomorrow — makes today’s market less than perfect and less than totally liquid. — Peter Bernstein (source)

Quote for the Week

It was the publication of E.L. Smith’s little book entitled, Common Stocks as Long-Term Investments. His study showed that, contrary to prevalent beliefs, equities as a whole had proved much better purchases than bonds during the preceding half-century. It is generally held that these findings provided the theoretical and psychological justification for the ensuing bull market of the 1920’s. The Dow Jones Industrial Average (DJIA), which stood at 90 in mid-1924, advanced to 381 by September 1929, from which high estate it collapsed — as I remember only too well — to an ignominious low of 41 in 1932.

On that date the market’s level was the lowest it had registered for more than 30 years. For both General Electric and for the Dow, the high point of 1929 was not to be regained for 25 years.

Here was a striking example of the calamity that can ensue when reasoning that is entirely sound when applied to past conditions is blindly followed long after the relevant conditions have changed. What was true of the attractiveness of equity investments when the Dow stood at 90 was doubtful when the level had advanced to 200 and was completely untrue at 300 or higher. — Ben Graham (source)