John Maynard Keynes’ General Theory
Chapter 12 and its lessons for investors
John Maynard Keynes’ General Theory: lessons for investors
Noted figures in the world of investment are often asked for a reading list by those who wish to emulate them. These lists will often include two books by Ben Graham (“The Intelligent Investor” and “Security Analysis”), Peter Lynch (“One up on Wall Street”), Phillip Fisher (“Common stocks and Uncommon Profits”), Monish Pabrai (“The Dhandho Investor”), the Annual Reports of Berkshire Hathaway and other books which are either favoured by the individual or happen to be popular at the time. Aspiring investors will obtain these books, but I fear few are read. Peter Lynch’s book reads like a Thriller and may well be an exception to this general rule. I have several Investment Classics gathering dust on my bookshelf which I earnestly hope to read one day.
Recently on Twitter, the thoughtful investor, Marcelo A. Lima posted the following:
I'm putting together a list of things investors should re-read every year.
Chapters 8 and 20 in The Intelligent Investor (Mr. Market & Margin of Safety) –
Chapter 12 of Keynes' General Theory (state of long-term expectations) –
Seven Sins of Fund Management (Montier) What else?
The reference to Chapter 12 of Keynes' General Theory was intriguing. This is the book, written in 1936, that launched the Keynesian Revolution in Macroeconomics which overthrew neo-classical economics. It was the basis of economic policy in the developed world from 1945 until the mid-1970s. It seems improbable that an Economics book written almost 100 years ago would have lessons for investors comparable to the writings of Ben Graham.
Two books from my bookshelf.
Benjamin Graham and John Maynard Keynes are unlikely bedfellows. The former was a child of immigrants who grew up in searing poverty in New York while the later was an upper class Englishman who was educated at Eton College and Cambridge University. Graham was an outsider in the Wall Street where he excelled while Keynes worked at the highest levels of government at the national and international level. He was the architect of the Bretton Woods system which defined the post-war global financial order.
However, there are also some extraordinary similarities between them. They were of a similar age (sort of). Keynes was born in 1883 and Graham was born in 1894. Both were brilliant polymaths - Keynes won a scholarship to Eton and got a first-class degree in Mathematics at Cambridge. Graham was a salutatorian (second rank in his class) at Columbia University and was offered a position as a lecturer in three departments there (English, Mathematics, and Philosophy) upon graduation. Economic pressures meant he left academia for Wall Street. Both Keynes and Graham were active in the stock market and suffered losses in the 1929 crash. They both published their seminal works in the middle of the great depression – 1934 for Graham and 1936 for Keynes.
The great depression was a prolonged period of unprecedented mass unemployment and collapsed output which had been triggered by the stock market crash. Classical economics said these things could not happen as market prices would adjust to allow markets to clear. For example, wages -the price of labour- would fall if the supply of labour exceeded the demand. Wages would fall until unemployment was significantly reduced.
In Keynes view, the overwhelming evidence of the time suggested that Classical Economic theory was deficient, and a revolution was required. The General Theory was the manifesto of the new paradigm. Chapter 12 focused on the stock market but it is incidental to the overall purpose of the book. In chapter 12, Keynes argues the stock market could be dominated by speculation and may not finance enough new investment to banish mass unemployment.
The chapter deals with process by which investors’ expectations of the long-term returns from stocks are formed. Keynes argues that investors just assume that the “existing state of affairs will continue indefinitely except in so far as we have specific reasons to expect a change.”. This convention applies even though the “actual results of an investment overall long term of years very seldom agree with the initial expectation”
He further writes “we are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts...and it will only change in proportion to changes in this knowledge.” This was written in 1936 but it is essentially a statement of the Efficient Market Hypothesis (EMH) which was formulated in the 1950s. EMH which states that asset prices reflect all available information and will only change because new information emerges”.
Keynes notes that professional investors are “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 conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is worth to a man who buys it “for keeps” but with what the market will value at under the influence of mass psychology, three months to a year hence.”
Keynes then outlines his famous analogy of a beauty contest. “Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole…”… “we (investors) devote our intelligence to anticipating what the average opinion expects the average opinion to be.”
Keynes considers whether an investor could succeed by ignoring the average opinion and taking a long-term view but dismisses it. “Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable” The problem for such an investor is that “ ..he should be eccentric, unconventional, and rash in the eyes of average opinion. .. worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
Keynes echoes Graham in emphasising the distinction between the speculative and the business-like investor. He used the term enterprise to describe the activity of the latter. Keynes viewed stock exchanges as casinos. “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done”
Keynes also noted a distinction which still applies today. The New York Stock Exchange in his view was more of a casino as the US investor looked for a capital gain while the UK investor looked to earn dividends. Keynes believed this did not reflect any differences in national character but the fact that bid-offer spreads, brokerage costs and dealing taxes were higher in London. He advocated the US introduce a substantial transfer tax on share transactions “ with a view to mitigating the predominance of speculation over enterprise in the United States.”
Keynes’ whole thesis in the General Theory was that unfettered free markets will not lead to desirable outcomes. Therefore, we should not be surprised that he should view the stock market as a casino. as an aside, we should note that Keynes was a very successful speculator for Kings College where he worked and managed College endowment from 1911 onwards. Keynes also promoted an Equity Fund in London and advised the Provincial Insurance company on its portfolio.
Ben Graham lost money in 1929 bubble and crash and had very good reason to wary of the speculative elements of the market. Chapter 8 of the Intelligent Investor “is a testament to that. Graham nevertheless believed that a disciplined enterprising investor with a conservative, rational method of approaching valuing companies could prosper over the long term. This proved to be the case for Graham and even more so for Graham’s most successful acolyte, Warren Buffett who started investing in earnest in the 1950s and has been doing so ever since.
Keynes in 1934 reached the same insights that Warren Buffet developed in the 1960s and 1970s. In August 1934, Keynes wrote to Francis Scott, the Provincial Insurance chairman, “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes”
3/04/2023