Let me tell you the story about three economists from history. These three men stand out as having the distinction of writing erudite works on economic theories while also amassing a fortune (and for some then losing it). Each of them has their own lessons in how to be a great investor, and why some but not all economists fail at investing.
When David Ricardo started out in business at the age of 21, his property base amounted to £800. By the time he died in 1823, a mere thirty years later, his estate was worth an unimaginable £675,000 to £775,000, from which he enjoyed a yearly income of £28,000. No other economist has reached this level of affluence.
Ricardo made most of his money early on as an arbitrager of government debt. Nevertheless, historians have debated the extent to which Ricardo profited from insider dealings and stock manipulations. Ricardo never wrote down his trading techniques, but business associates said that he held scrupulously to his two “golden rules”: “Cut short your losses” and “Let your profits run on.”
Ricardo’s budding financial career took a gigantic leap forward when he began bid-ding as a loan contractor for the government. During the Napoleonic wars in the early 1800s, the government relied on the Stock Exchange to finance its burgeoning expen-ditures. The successful bidders received a special bonus from the chancellor of the exchequer. Ricardo and company were so successful in their bidding that they obtained every government loan during the war years of 1811 through 1815.
The last and biggest loan of the war (worth £36 million) was raised on June 14, 1815, just four days before the Battle of Waterloo. The price of the bonds was extremely depressed because of the size of the loan and the uncertainty of the outcome of the war. There were four bidders for the loan contract, but Ricardo’s firm won.
Ricardo bravely held onto his position in the deeply depressed bonds, his biggest gamble ever. Other more timid investors sold early, before the Battle of Waterloo but not Ricardo. After the news arrived that Wellington had won the battle against Napoleon the government consols sky-rocketed and Ricardo became an instant millionaire. The Sunday Times reported in Ricardo’s obituary (September 14, 1823) a popular rumor that during the Battle of Waterloo Ricardo had “netted upwards of a million sterling”.
Ricardo fell short of being counted as one of Britain’s 179 millionaire, but was one of the 338 who had at least half a million pounds. It was then almost by chance that Ricardo turned his attention to economics eventually developing a theory of comparative advantage and cementing his place as the father of international trade.
Lessons for investors:
-Cut short your losses and let your profits run on.
-Stick to those areas where you know the knowable. Although it can be argued that Ricardo profited from insider dealing he stuck to the area that he had an edge.
2. Irving Fisher
Fisher invested heavily in the stock market during the 1920’s favouring start-ups with innovative products. To juice his returns he borrowed heavily in order to leverage his capital. As the market carried on rising he accumulated $10 million. The danger of course with leverage is that it also works in reverse, multiplying your losses when the market falls. In 1929 when the stock market crashed Fisher was brought to financial ruin.
In October 1929, shortly before the crash Fisher declared that the stock market had reached a ‘permanently high plateau’. In the weeks after the crash he told an audience at the National Association of Credit Men that he believed nothing fundamental had changed at that they should ride out the storm in the markets.
The irony was that Fisher had pioneered the development of economic data (The Index Number Institute published weekly and monthly economic indicators), and so would have been well placed to observe the imbalances and vulnerabilities building up in the economy.
After his death the net value of his estate was estimated at just $60,000.
Lessons for investors:
-Avoid confirmation bias. Fisher wrote extensively in the build-up to the crash in support of rising markets. He was a proud man and hated to be proved wrong. You could argue that his sense of self was so wrapped up in rising markets that to sell out would have (in behavioural economics speak) given him cognitive dissonance.
-Understand your motivations. Fisher was constantly trying to amass a large fortune to prove his worth.
-Data by itself doesn’t mean you are a better investor.
3. John Maynard Keynes
Keynes, like Ricardo and Fisher before him was an investor. In 1936 he was worth over £500,000, he then nearly went bankrupt in the 1937–38 recession having been heavily leveraged. At his death in 1946 he had an investment portfolio of £400,000.
His observations of speculators prompted him to shape his famous ‘animal spirits’ description of investors. He defined animal spirits as ‘a spontaneous urge to action rather than inaction and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities’.
This framed his view of investors:
“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 teach 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 judgement are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligence’s to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”
Lessons for investors:
-Investment is not just about interpreting the data, its about interpreting how every other investor interprets the data and how every investor responds to the actions of other investors.