Academic journal article Proceedings of the American Philosophical Society

The (Non) Lessons of History-And the (Real) Lessons of Return Sources and Investment Costs 1

Academic journal article Proceedings of the American Philosophical Society

The (Non) Lessons of History-And the (Real) Lessons of Return Sources and Investment Costs 1

Article excerpt

For virtually my entire career in finance-now more than 61 years-two of the greatest economists of the past century have played a major role in my understanding of the financial markets. One is John Maynard Keynes, the legendary British theorist and author. The other is Paul Samuelson, the prolific generator of ideas and the first American to win (in 1970) the Nobel Memorial Prize in the Economic Sciences.

My own academic credentials are modest to a fault: a bachelor of arts degree (albeit with high honors) from Princeton University in 1951. No M.B.A., no Ph.D. Only an A.B. Despite my limits, I was invited to become a member of the American Philosophical Society in 2004, perhaps because I've stood on the shoulders of these two economic giants during so much of my career. In many respects, the inspiration of Keynes and Samuelson underlies the creation of Vanguard in 1974 and the world's first market index mutual fund in 1975. Day after day, scores of investors assure us that we've given them a new way-and a better way-to put their capital to work.

My first encounter with both of these economists came at Princeton, where in 1948, I was introduced to the study of economics. Our textbook was the very first edition of Dr. Samuelson's Economics: An Introductory Analysis (now in its nineteenth edition). My ability to understand what would become my major field of study was no more than, shall we say, adequate. But of all the reading that I did in my field of concentration, it was Keynes's The General Theory of Employment, Interest, and Money, published in 1936, that has stayed at the forefront of my mind to this very day.

John Maynard Keynes

Although there's a lot of dense doctrine in that timeless book, I was particularly struck by chapter 12, "The State of Long-Term Expectation." There, Keynes made a critical distinction between the two broad reasons that explain the returns on stocks. The first was what he called enterprise-"forecasting the prospective yield of an asset over its entire life." The second was speculation-"forecasting the psychology of the market."

Keynes was confident that speculation would dominate enterprise as a market force. In those days, individual investors were the predominant owners of stocks and the major players in the stock market. Because such investors were largely ignorant of business operations or valuations, Keynes explained, their trading would lead to excessive, even absurd, short-term market fluctuations based on events of an ephemeral and insignificant character. Short-term fluctuations in the earnings of existing investments, he argued (correctly), would lead to unreasoning waves of optimistic and pessimistic sentiment. (Keynes was ahead of his time!)

Although competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, should correct the vagaries caused by ignorant individuals, Keynes added, the energies and skills of the professional investor would also come to be largely concerned not with making superior long-term forecasts of the probable yield of an investment over its whole life (enterprise), but with foreseeing changes in the conventional basis of valuation (speculation) a short time ahead of the general public. Keynes therefore described the market as "a 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."

In my 1951 Princeton senior thesis on the mutual fund industry, I cited Keynes's conclusions. And this callow young kid had the temerity to disagree with the great man. Rather than succumbing to the speculative psychology of ignorant market participants, I argued, these investment professionals would focus on enterprise. In what I predicted -accurately, as it turned out-would become a far larger mutual fund industry, our portfolio managers would "supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic, a demand that is based essentially on the [intrinsic] performance of the corporation rather than the public appraisal reflected in the price of its shares. …

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