Stock Prices are Even Less Efficient Than You Think

Within financial academia, there are three main groups of thinking regarding public equity pricing, all of which stem from the efficient-market hypothesis and depend on it to varying degrees. The strong form of market efficiency thinkers believe stock prices reflect all information that can be known about any business, including insider information, and that stock prices are wholly unexploitable for above-average risk-adjusted returns. The semi-strong form group believes prices immediately reflect public information only, given we have laws against insider trading and that it is clear insider information can give an advantage. They also believe that since stock prices reflect all public information, fundamental analysis is useless in delivering above-average returns as business values would be reflected in stock prices. Those in the weak form group believe stock prices only reflect past public information and that fundamental analysis, while studies show it is rare, may provide benefits.

All groups believe technical analysis isn’t useful in predicting future prices and/or delivering returns for investors, and academics have done a good job of falsifying the validity of charting in equities markets with many studies of past data testing typical charting techniques. On this point at least, they have come to a general consensus.

Unfortunately (fortunately), fundamental analysis isn’t easily testable given that “valuation models” as they put it, may not accurately estimate business values ex-ante, so any study would be a test of both a valuation model and the efficient market hypothesis. What this means is that proper valuation requires inputs and some degree of individual assessment, generally regarding future growth and profitability, which are unknowable or impossible to make standards on when attempting to value a group of companies. The problem is that each company needs different growth and profitability inputs, as they will all grow at differing rates in the future, and must be assessed one by one and everyone’s estimate of the proper numbers would differ, leading to different estimated values. This is why they have to test financial ratios such as P/E and P/B instead. As a result, most of the work of academia consists of theorizing on the topic as it cannot be empirically tested.

It is almost humorous that they cannot as a field of academia come to a consensus on how to value companies, given that they understand this ex-ante valuation problem but they expect that the general equities market and all of its participants can. If 5 financial academics were asked to value the same company on the basis of its future free cash flows as should be done, they will come to wildly different results yet it is believed by many that the market somehow comes to the proper or best-estimate result as a group in real-time. The present value of a firm represents the discounted value of all cash flows the firm will ever accrue, so clearly it is going to be an impossible task to get any group of people to agree on it even within a range.

To see the problem very easily, feel free to try to estimate how much money you will ever make, and then ask a family member to estimate that value, and then a friend- nobody will agree on a number and all of you will be wrong to some degree. The stock market is kind of like if everyone in the world could also estimate how much money you’ll make and they would be informed of your life and change their answers based on how you’re doing financially- some technical analysts will even change their answers based on how others have changed their answers! If you don’t even know how much you’ll make, even within a wide range, it’s clear that most of the other people who estimate won’t either. The problem is much harder for young people and the estimates will be highly inaccurate, just like the stock prices of early-stage companies, for which many things are uncertain.

In any case, it is obvious that stock markets immediately reflect only public information, but I believe the academic scale of market efficiency misunderstands how stock prices are set and change over time based on the actions of all market participants. The weak-form group is undoubtedly closest to the truth, but they haven’t publicly analyzed or protested against the many details necessary to believe in semi-strong market efficiency.

I believe the mainstream view of market efficiency harbored by most investors and consumers is somewhere between the weak and semi-strong form, with most people believing that most of the time stock prices make sense. I disagree and outline my reasoning below.

The stock market is an auction market like which any other, reflects market-clearing prices. Equilibrium prices change constantly based on changes in both supply and demand, and supply and demand are both ever changing and dependent on many variables. The variables affecting supply and demand of any stock are numerous but many of them are random, unpredictable, and subject to completely unrelated and/or arbitrary factors.

In general, it seems to be the view of most financial professionals that even if stock prices don’t reflect true value, they at least reflect the expectations of investors regarding the future of any business and therefore are close to a best estimate in most cases. There are many examples however, which invalidate the claim that stock prices are dependent only on logical expectations of the future and therefore the present value of the business and its stock price.

If a hedge fund has a large short position in a single stock but has taken losses on the position affecting the fund’s equity and/or available margin, the fund manager may be forced to close the position. Closing a large short position would dramatically increase the stock price and should increase price proportionally to the percentage of the firm’s float the short position was. This is why short-squeezes cause such a dramatic increase in stock prices- they force short sellers to cover positions and demand rapidly rises despite the fact that the short-sellers may want to keep shorting. The average expectations of the business in this case do not rise nearly as quickly as the stock price.

Executives and directors can execute and sell options in an arbitrary and random manner, oftentimes relative to their cash needs. If a firm’s executive is granted a percentage of the outstanding in the form of options and soon after liquidates it for the purchase of a house lets say, then these random transactions have each affected the stock price without regard for the value of the firm and have in total combined for a larger effect on the stock price than any of them individually would have. The options grant diluted current owners and should affect the share price in a manner proportional to its percentage of the outstanding, and the execution/sale of the stock would then increase the supply of stock without increasing demand.

If a firm’s founder and executive passes away and leaves his/her heirs with a 20% position in a public company, their arbitrary decisions will have a dramatic effect on the stock price. Once again, if they decide to sell the whole stake, the price of the firm should drop dramatically as long as demand remains constant, as they wouldn’t be soaked up at the current price, so price would drop until the market clears. Investor’s expectations of the firm haven’t changed, but the price has dramatically.

The January effect is real. More than a few studies show prices tend to do poorly in December when large funds sell in an attempt to realize losses and improve after-tax returns for that year, while January’s returns are much better as the stocks are bought up again.

A profound and obvious example is when a stock is either invited into or removed from an index. When a stock enters an index fund, suddenly demand explodes and the price of the company rises, and the exact opposite happens when they are removed from indices. Millions of unknowing investors have suddenly purchased or sold ownership in the firm and in a blink its price has dramatically changed. This, along with spin-offs, are prominent examples of transactions which affect prices for no good reason other than disinterest. The transactions just indirectly affect demand, so purchases or sales are made without regard for the present value of the company.

A last example is a technically-guided firm with high volumes making large trades based on ‘signals’ coming from the stock price chart. Their ‘signals’ are based on the purchases and sales of others and of course any transactions they make based on the transactions of others aren’t related to the value of the business but will affect price. Let’s imagine a perfect market in which investors estimate the future quite well and so prices are close enough to fair value and enter Technical Firm A. If something happens which actually changes the value and stock price of the business to its new fair value, the Technical Firm A would look at the new fair value, assume something happened from the change in price and then act on it to bring the price to a new and inaccurate price. Whatever ‘signal’ Firm A deciphered from the price change would without cause lead them to affect the price. The rest of the market could once again attempt to bring prices back to order to its previously found price, but it would continue to send ‘signals’ to Firm A to do something so that the stock price is at all times off by a wide margin.

There are infinite examples, but clearly rational expectations are not the only determinant of price and price swings. All of the above are akin to sudden and random shifts in the supply or demand of a good and affect price merely because of changes in outstanding quantity available and/or desired for unrelated reasons.

Further, the market’s expectations aren’t even the market’s expectations. Each market participant has an opinion on the firm’s future and present value given their expectations, yet each has dramatically different ownership and/or stock volume to affect prices. Therefore, when expectations are priced in, they are closer to the market’s weighted-average expectations. Investment Institution A may think a company has a great future and purchase, but if much larger Investment Institution B believes the opposite and sells at a much higher volume, then prices will decline. Investment Institution B’s opinion of course has a much greater effect on the stock price and yet it may be a misguided opinion as to the firm’s future and/or value. Investment Institution B’s selling could come from one of its funds which is managed by a single portfolio manager. Even if those two institutions disagree as to the firm’s future growth by 50% (will the firm grow at 10% a year or 15% a year for the next 5-10 years?) it could impact each investor’s estimated value of the company and their purchase/sale decisions. This would also ignore the possibility that Investment Institution B is selling for an unrelated reason and that all transactions are made based upon their assessment of the firm’s value.

Any investment fund could at this moment randomly decide to buy a large stake in a tiny public company and immediately and dramatically increase its price. It is highly unlikely that the market would respond by selling an equivalent amount of stock so as to revert back to the old price, which would happen in a perfectly value-efficient stock market. It is more likely that this purchase has just randomly increased demand for the stock by the amount of shares purchased, and the stock price will as a result just be higher than what it would otherwise be. Someone could stumble upon the price and say that it is the fair price or that it reflects the market’s expectations, but if the fund sells its stake 5 years later creating a large price drop, it makes little sense to say either the purchase or sale changed the value of the business, or that they were made because of changes in the value of the business. The fund could make these purchases and subsequent sales for fun in July of each year and affect demand and therefore the stock price on an annual basis. Every July you would see a dramatic rise in the stock price and soon after a large drop, regardless of what is happening with the company.

Also related to the question of how implicit expectations of the future manufacture prices is the understanding that each investor would have to form an opinion as to the future, use those expectations to estimate the stock’s present value, and then transact in the appropriate manner based on the distance of the firm’s price from their estimate. This would be the perfect market which would render the above mentioned fund’s July transactions irrelevant as changes in price away from fair value would be reversed as everyone mechanically transacts to eliminate them. The idea that every investor cares about the current price and has compared it to some estimate of their creation is questionable. Another point is that many funds do not short stocks even if they have a pessimistic opinion of it, and so this is one example of many participants who are unable or unwilling to act on their opinion for some reason or another.

Diving into each investor’s estimates also begs the question of how they will change these estimates of value based on future information. If some new information comes out it may be meaningless to some and relevant to others. It is not as if investors all agree as to the relevance of information and its impact on pricing, because they certainly don’t.

One further point is that one’s estimate of present value is always dependent on required returns and everyone’s required returns are different. If I’ll be fine with 5% returns and you need 10% returns, I’ll pay 100% more for every company than you would, even if our expectations are exactly the same. We would have to reconcile both differences in required returns and future expectations for every market participant in order for the weighted-average to make much sense. If our expectations are different, I might expect a 5% annual return from the company at a certain price while you expect a 20% return. It starts to devolve into complete nonsense if we try to pick apart the motives of each market participant and their effect on stock prices as there are far too many factors involved.

Nearly every investor will have differing expectations to some degree, with some on the low-end and others at the high-end. There are others which may be shorting the company as well if they have very low-expectations relative to price. Clearly one of the two groups is wrong if the expectations of the short-sellers are compared to those of the firm’s most ardent supporters. The stock price reflects the opinion of neither party, but somewhere in between depending on the volumes of each party. It is also possible that if the stock has one highly pessimistic short-seller with massive volume, and many ardent but very small buyers at any price, the price could be much closer to the short-seller’s expectations than anyone else’s. If the price is closer to the short-seller’s estimate than anyone else’s, should it be said that he has a better estimate of value than everyone else because he has a larger position?

Imagine if offered a poll asking everyone how many super bowls the Denver Broncos will win in the next 50 years. If everyone had one vote, could publish the average and despite the fact that estimates could range anywhere from 0 to 10 plausibly, this would be a real averaged result. The result of this average would be meaningless but it could be said it represents the market’s expectations. If however, 1 million people had 1 vote and 100 people had 1 million votes each, then the votes of the 1 million people would become irrelevant in determining the average. If 20% of the people with 1 million votes each had estimates 50% above the future actual result (broncos fans maybe), the market average estimate would have been far too high based on the poor estimates of a select few. If the poll was done after a Broncos win and then once again after a Broncos loss a week later, the average may change dramatically and likely illogically.

The academic question of how quickly markets react to information and which information it reacts to are somewhat misguided, and the scale doesn’t reflect many of the variables that affect prices. The academic version of ‘react’ is also a misnomer and generally implies a logical and collective inference of all participants in unison. The market has the ability to react immediately to information but in an unintelligible and jumbled manner as everyone has differing incentives and opinions, which generally leads to a meaningless result.

Prices will oftentimes be in a wide range around a decent guess as to the present value of any stock, but particularly when the firm’s future results are difficult to predict given uncertainty in the industry, the potential of some technology or product, the stability of the industry, or when it is difficult to know how long rapid growth of a company can continue for, the range of expectations can vary wildly. Technology in particular can be extremely difficult to assess as it is rapidly changing. How long a firm can grow at above average rates can be impossible to know, just as when the rapid decline will occur can also be cloudy. Most investors wouldn’t even be able to agree on a ballpark estimate of how long many firms will operate for. For some companies a plausible guess could be anywhere from 10 to 100 years+, and if expectations of growth differ, the difference in valuation can be remarkable. There are many things which cannot be known as to the near future, even by the world’s experts in some fields. In most cases, I do not think it is possible to know most things about even the very near future, not to mention the long-run. Does anyone know exactly how the world and everyday life will change in the next 5-10 years?

All of the above points questioning market rationality apply in ‘normal times’, meaning in periods of average liquidity and without crises. We have to, of course, also add to our equation the factor of random shocks to both equity demand and supply leading to massive reductions in liquidity as everyone wants to sell which happens each recession and rapidly reduces average stock prices. Prices generally revive within 1-3 years after a recession, but they change dramatically simply because demand temporarily plummets at the same time that supply skyrockets and so prices take a while to reach their previous levels. Along with that, there is also the impact of miscellaneous crises such as weather and politics which may or may not affect business values but can make investors feel as if they have or will have some impact on value, so they have the capacity to wildly affect prices either for valid reasons or no good reason at all. Of course in some cases it may not be possible to know to what degree the reasons are valid or not.

I’ve used the chart below in another article, but it was created by Robert Shiller in 2013 to assess differences between price and value for the S&P 500. The blue ‘Present Value’ line is the actual value of the S&P 500 using all future dividends discounted to that point in time, whereas the red line is the price of the S&P 500. If you could perfectly predict the value of every company in the index, any point on the blue line represents the price you would be willing to pay for a share of the index based on interest rates at the time. If you buy above the line, you will get below-average returns, and if you buy below it you will get above-average returns.


The chart cannot necessarily invalidate any claim regarding the determinants of stock prices, but it shows how wildly they fluctuate in comparison to company values. Particularly in recessions when liquidity completely dries up and prices plummet, values haven’t changed much at all. The companies were of course the same as they were prior to any crash. The present value of a company includes all future years it will ever have, so one year of poor results in reality does little to that value. There are also boom years where prices remain far above fair values for years, even over a decade on end.

If you notice the end of the chart, the red line drops and converges on the blue. This is because those years are very close to the date of the chart creation in 2013 and so do not and cannot accurately describe future dividends. The years 2000 on in this chart would likely all need to be revised in the future.

If we are to believe that stock prices merely reflect expectations of the future, then expectations must change wildly. 1920, 1929, 1932, 1937, and 1942 are quite a ride and between each year mentioned either expectations changed wildly (without good cause), or other factors such as random drops in demand occurred. Between 1937 and the end of 1942, the market crashed, regained most of its losses, and once again crashed. Those were of course tenuous and difficult times in which prices were affected dramatically by political policy and liquidity, but nonetheless the value of the S&P 500 was slowly increasing through those years.

The random liquidity factor also has to be examined to some degree, as thinking about massive drops in liquidity as exogenous shocks outside of the control of all investors is almost certainly fallacious. Recessions undoubtedly occur with regularity and seemingly at random, but the reactions to them through the changes in stock prices shown above cannot be valid. Investor expectations may be highly volatile and ever changing during these periods, but they are unlikely to be rational. If this is a world where emotions don’t affect prices, then there would have to be constant and major errors in logic. The expectations of the future would in these periods have to be wildly incorrect and fluctuating to a very high degree. Margin and leverage play some factor via forced selling, but I don’t think they are the fundamental driver of stock sales and the extent of the price declines in these times.

It seems that changes in expectations of the future of the top 500 companies in the U.S. from -50% to 100% and back again in a few years time would be a poor explanation of the changes in price. It also breaks any claims of the rationality of stock price volatility in both booms and recessions and given that investors still make decisions in these periods out of free will, for whatever reason they change their minds rapidly. Unfortunately, prices never seem to stay near fair value for long, rather they are always significantly above or below and moving far too quickly. Equities markets are fickle to say the least.

At best it could be said the market is mistakenly changing expectations based on short-term phenomena and just constantly overshooting the distant future based on what the economy and each business is doing in the present, but it seems much more plausible to say that it is simply irrational and born out of emotion (not that imagining a constantly linear economy based on recent results is logical anyways). Many forget that growth will not continue forever at the peak of a boom and they also forget that losses will subside at the bottom of a recession. That effect is likely emotional rather than having anything to do with expectations of the future.

So if we were to try to sum up this article so far and market efficiency in general, we would have to say something close to the following:

In most times with normal liquidity, stock prices will be affected both by the market’s weighted-average expectations of the future, which may or may not be properly baked into prices, as well as random and unpredictable transactions which do not relate to the value of companies. Prices will generally be too high in good times and too low in bad times, possibly due to misguided expectations and they will change rapidly without good cause and almost always overshoot. Whether due to mistakes in reasoning or emotion run rampant, at nearly all times stock prices are incorrect and moving while business values grow slowly.

That statement would of course assume investors are transforming their expectations of companies into numerical estimates of value in normal times. The chart used the top 500 largest companies in the economy in each year, and we would have a tougher task trying to assess what is happening if we looked at the historical prices of 1000 smaller companies.

To say however, as many do, that because the largest companies in the stock market are followed by many, their prices will reflect good-enough estimates of value and/or logical expectations of the future as to be unexploitable would be an extremely difficult claim to stand by when put to the test.

Within the group of those who believe it is possible to exploit market pricing, I am likely at the very far end in terms of disbelief in market efficiency if we are discussing its ability to create logical prices. Market prices are always incorrect to some degree (incorrect meaning the stock will deliver returns implied by its price far outside a normal range of required returns), they change too often without cause, and the changes in most cases tend to either relate to non-value factors (random buying/selling) or inexplicable changes in expectations. Further, if you are in boom times most companies will be priced too high and in a crash nearly every company will be priced too low. You could have just randomly picked stocks out of a hat in early 2009 and done very well.

The market responds immediately to news that may be relevant and of course the price perfectly reflects supply and demand at any point in time. However, stock prices and their movements are clouded by random transactions, the irrational/emotional whims of participants, dramatic changes in liquidity, as well as the differing opinions, motives, and assessments of all parties and as a result often does a poor job of reflecting fair expectations of the future as prices reflect the muddled confluence of all these factors.

To conclude, I’ll post below a passage from Keynes’ General Theory of Employment, Interest and Money in which he writes on market activity. It’s a few pages from the book and is a long passage, but worth the read.

“In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention—though it does not, of course, work out quite so simply—lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely. The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalise our behaviour by arguing that to a man in a state of ignorance errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads to absurdities. 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 which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation. In point of fact, all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield.

Some of the factors which accentuate this precariousness may be briefly mentioned.

(1) As a result of the gradual increase in the proportion of the equity in the community's aggregate capital investment which is owned by persons who do not manage and have no special knowledge of the circumstances, either actual or prospective, of the business in question, the element of real knowledge in the valuation of investments by whose who own them or contemplate purchasing them has seriously declined.

(2) Day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market. It is said, for example, that the shares of American companies which manufacture ice tend to sell at a higher price in summer when their profits are seasonally high than in winter when no one wants ice. The recurrence of a bank-holiday may raise the market valuation of the British railway system by several million pounds.

(3) A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield; since there will be no strong roots of conviction to hold it steady. In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual even though there are no express grounds to anticipate a definite change, the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.

(4) But there is one feature in particular which deserves our attention. It might have been supposed that competition 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 conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it 'for keeps', but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.

Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced. This is the inevitable result of investment markets organised with a view to so-called 'liquidity'. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of 'liquid' securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is 'to beat the gun', as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.

This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional;—it can be played by professionals amongst themselves. Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs—a pastime in which he is victor who says Snap neither too soon nor too late, who passed the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.

Or, to change the metaphor slightly, 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; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investments on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets. Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough;—human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money—a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally 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 behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm 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. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

(5) So far we have had chiefly in mind the state of confidence of the speculator or speculative investor himself and may have seemed to be tacitly assuming that, if he himself is satisfied with the prospects, he has unlimited command over money at the market rate of interest. This is, of course, not the case. Thus we must also take account of the other facet of the state of confidence, namely, the confidence of the lending institutions towards those who seek to borrow from them, sometimes described as the state of credit. A collapse in the price of equities, which has had disastrous reactions on the marginal efficiency of capital, may have been due to the weakening either of speculative confidence or of the state of credit. But whereas the weakening of either is enough to cause a collapse, recovery requires the revival of both. For whilst the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition.

These considerations should not lie beyond the purview of the economist. But they must be relegated to their right perspective. If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase. In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market. It is rare, one is told, for an American to invest, as many Englishmen still do, 'for income'; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that, when he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation, i.e. that he is, in the above sense, a speculator. 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. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism—which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous 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—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die;—though fears of loss may have a basis no more reasonable than hopes of profit had before.

It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death.

This means, unfortunately, not only that slumps and depressions are exaggerated in degree, but that economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average business man. If the fear of a Labour Government or a New Deal depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with political intent;—it is the mere consequence of upsetting the delicate balance of spontaneous optimism. In estimating the prospects of investment, we must have regard, therefore, to the nerves and hysteria and even the digestions and reactions to the weather of those upon whose spontaneous activity it largely depends.

We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady, and, even when it is not, the other factors exert their compensating effects. We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.”