The Four Pillars of Investing by William J. Bernstein

 This is second great book on common sense investing after John Bogle's classic "The little book of Common Sense Investing". Here are my reading notes from the book.

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• The investment management industry is obsessed with studying past trends and using them to predict the future. Unfortunately - a good advisor or investor understands that the past has little meaning, and the future cannot be predicted. Asset allocation, as a result, is a sound strategy for all investors. The biggest risk of all is failing to diversify properly.
• The only function of economic forecasting is to make astrology look respectable – John Kenneth Galbraith.
• When a broker calls suggesting that the price of a particular stock will rocket, what he’s really telling you is that he is not overly impressed with your intelligence. Otherwise, you would realize that if he actually knew that the price was going to increase, he would not tell it to you or even his own mother. Instead, he would quit his job, borrow to the hilt, purchase as much of the stock as he could, and then go to the beach.
• It’s the behavior of your portfolio as a whole, and not the assets in it, that matters most.
• People tend to be attracted to financial choices that carry low probabilities of high payoffs. In spite of the fact that the average payoff of a lottery ticket is only 50 cents on the dollar, millions “invest” in it. While this is a relatively minor foible for most, it becomes far more menacing as an investment strategy. One of the quickest ways to the poorhouse is to make finding the next Microsoft your primary investing goal.

Higher the Risk, higher the Return

• Assets with higher returns invariably carry with them stomach-churning risk, while safe assets almost always have lower returns. The best way to illustrate the critical relationship between risk and return is by surveying stock and bond markets through the centuries.
• At one time or another, most of us have seen a plot/graph of capital wealth shooting upward demonstrating that $1 invested in the U.S. stock market in 1790 would have grown to more than $23 million by the year 2000. Unfortunately, for a number of reasons, no person, family, or organization ever obtained these returns. Considering commissions and taxes, return would have shrunk by one percent or two, reducing a potential $23 million fortune by $3 million. Also, only few investors have the patience to leave the fruits of their labor untouched. Even more importantly, this is Survivorship bias, a term refers to the fact that only the best outcomes make it into the history books; those financial markets that failed do not. Also, October 1987 U.S market crash drove millions of investors permanently out of the stock market. For a generation after the 1929 crash, the overwhelming majority of the investing public shunned stocks altogether.
• Nowhere is historian George Santayana’s famous dictum, “Those who cannot remember the past are condemned to repeat it,” more applicable than in finance. Financial history provides us with invaluable wisdom about the nature of the capital markets and of returns on securities. Intelligent investors ignore this record at their peril.
• At a very early stage in history we are encountering “survivorship bias”—the fact that only the best results tend to show up in the history books. In the twentieth century, for example, investors in the U.S., Canada, Sweden, and Switzerland did handsomely because they went largely untouched by the military and political disasters that befell most of the rest of the planet. Investors in tumultuous Germany, Japan, Argentina, and India were not so lucky; they obtained far smaller rewards. Thus, it is highly misleading to rely on the investment performance of history’s most successful nations and empires as indicative of your own future returns.
• The moral here is that because the most successful societies have the highest past stock returns, they become the biggest stock markets and are considered the most “typical.” Looking at the winners, we tend to get a distorted view of stock returns. It helps to recall that, three centuries ago, France had the world’s largest economy and just a century-and-a-half ago, that distinction belonged to England.
• If someone thinks he could have invested in performing economies, this again is an example of “hindsight bias”; in 1913 it was by no means obvious that the U.S., Canada, Sweden, and Switzerland would have the highest returns, and that Germany, Japan, Argentina, and India, the lowest.
• High previous returns usually indicate low future returns, and low past returns usually mean high future returns. The rub here is that buying when prices are low is always a very scary proposition. The low prices that produce high future returns are not possible without catastrophe and risk. The recent very high stock returns in the U.S. would not have been possible without the chaos of the nineteenth century and the prolonged fall in prices that occurred in the wake of the Great Depression.
• In Greece, a common business was that of the “bottomry loan,” which was made against a maritime shipment and forfeited if the vessel sank. A fair amount of data is available on such loans, with rates of 22.5% for a round-trip voyage to the Bosphorus in peacetime and 30% in wartime. Since it is likely that fewer than 10% of ships were lost, these were highly profitable in the aggregate, though quite risky on a case-by-case basis. This is one of the first historical demonstrations of the relationship between risk and return: The 22.5% rate of interest was high, even for that period, reflecting the uncertainty of dealing with maritime navigation and trade. Further, the rate increased during wartime to compensate for the higher risk of cargo loss. Another thing we learn from a brief tour of ancient finance is that interest rates responded to the stability of the society; in uncertain times, returns were higher because there was less sense of public trust and of societal permanence. This is classic example of high risk, high return.
• Two Nobel Prize-winning economists, Franco Modigliani and Merton Miller, realized more than four decades ago that the aggregate cost of and return on capital, adjusted for risk, are the same, regardless of whether stocks or bonds are employed.
• Value of a long-term bond or loan in the marketplace is inversely related to the interest rate. When rates rise, the price falls; when rates fall, the price rises.
• It’s pretty clear that there’s a relationship between return and risk—you enjoy high returns only by taking substantial risk. If you want to earn high returns, be prepared to suffer grievous losses from time to time. And if you want perfect safety, resign yourself to low returns. In fact, the best way to spot investment fraud is the promise of safety and very high returns. If someone offers you this, turn 180 degrees and do not walk - run.

Stock vs. Bonds

• Two Nobel Prize-winning economists, Franco Modigliani and Merton Miller, realized more than four decades ago that the aggregate cost of and return on capital, adjusted for risk, are the same, regardless of whether stocks or bonds are employed.
• Value of a long-term bond or loan in the marketplace is inversely related to the interest rate. When rates rise, the price falls; when rates fall, the price rises.
• A bond is simply a loan. Most often, bonds have a sharply limited upside: the best that you can do is collect your interest payments and principal at maturity. A share of stock, on the other hand, represents a claim on all of the future earnings of the company. As such, its upside is potentially unlimited.
• It is, of course, quite possible to suffer a 100% loss with either. If a company goes bankrupt, both its stocks and bonds may be worth nothing, although bondholders have first claim on the assets of a bankrupt company. The major difference between stocks and bonds occurs during inflation. Because a bond’s payments are fixed, its value suffers during inflationary periods; it may become worthless if inflation is severe enough. Stocks are also damaged by inflation, but since a company can raise the price of the goods and services it produces, its earnings, and, thus, its value, should rise along with inflation.
• This is not to say that stocks are always superior to bonds. Although stocks often have higher returns because of their unlimited upside potential and inflation protection, there are times when bonds shine.
• Distilled to its essence, investing is about earning a return in exchange for shouldering risk. Return is by far the easiest half, because it is simple to define and calculate, either as “total return" or as “annualized return". Risk is a much harder thing to define and measure. It comes in two flavors: short-term and long-term.
• Bonds, on one hand, do occasionally lose money; stocks on other hand lose money in one of every three years, sometimes, they lose a lot. In fact, stocks can behave badly for years at a time. For example, from 1973 to 1974, stocks lost about 40% of their value, while inflation reduced the value of a dollar by nearly 20%, for an after-inflation cumulative loss of about one-half. And from the market peak in September 1929 to the bottom in July 1932, the market lost an astonishing 83% of its value. The loss was mitigated, however, by the approximate 20% fall in consumer prices that occurred during the period. The market recovered strongly after 1932, but in 1937, another drop of about 50% occurred.
• Many investors cling to the belief that by following the right indicator or listening to the right guru, they can reduce risk by avoiding bear markets. But the pattern of annual stock returns is almost totally random and unpredictable. The return in the last year, or the past five years, gives you no hint of next year’s return—it is a “random walk.” Expect at least one, and perhaps two, very severe bear markets during your investing career.
• Paradoxically, in the long run, bonds are at least as risky as stocks. This is because stock returns are “mean reverting.” That is, a series of bad years is likely to be followed by a series of good ones, repairing some of the damage. Unfortunately, this is a two-edged sword, as a series of very good years is likely to be followed by bad one. People often used to demonstrate that stocks become “less risky” over time by plotting graphs but it’s easy to make graphs lie.
• Bonds are even worse, since their returns do not mean revert - a series of bad years is likely to be followed by even more bad ones, as happened during the 1970s in America.
• Long-duration bonds are generally a sucker’s bet—they are quite volatile, extremely vulnerable to the ravages of inflation, and have low long-term returns.

Staying the Course

• Short-term risk, occurring over periods of less than several years, is what we feel in our gut as we follow the market from day to day and month to month. It is what gives investors sleepless nights. More importantly, it is what causes investors to bail out of stocks after a bad run, usually at the bottom. And yet, in the long-term, it is of trivial importance. After all, if you can obtain high long-term returns, what does it matter if you have lost and regained 50% or 80% of your principal along the way?
• This, of course, is easier said than done. Even the most disciplined investors exited the markets in the 1930s, never to return. Obsession with the short term is ingrained in human nature; the impulse is impossible to ignore. Your short-term investing emotions must be recognized and dealt with on their own terms. It is an easy thing to look at the past data and convince yourself that you will be able to stay the course through the tough times. But actually doing it is an entirely different affair.
• Examining historical returns and imagining losing 50% or 80% of your capital is like practicing an airplane crash in a simulator. Trust me, there is a big difference between how you’ll behave in the simulator and how you’ll perform during the real thing. During bull markets, everyone believes that he is committed to stocks for the long term. Unfortunately, history also tells us that during bear markets, you can hardly give stocks away. Most investors are simply not capable of withstanding the vicissitudes of an all-stock investment strategy.
• The best possible time to invest is when the sky is black with clouds, because investors discount future stock income at a high rate. Here also, our psychological and social instincts are a profound handicap. The purchase of stocks in turbulent economic times invites disapproval from family and peers. Of course, only in retrospect is it possible to identify what legendary investor Sir John Templeton calls “the point of maximum pessimism”.

Truths about Active Money Management

• Stockbrokers and mutual fund companies  are not your friends, and the interests of the fund companies are highly divergent from yours. They exist for one purpose: the extraction of fees and commissions from the investing public.
• Almost all the differences in the performances of money managers can be ascribed to luck and not to skill; you are most certainly not rewarded for trying to pick the best-performing stocks, mutual funds, stockbrokers, or hedge funds.
• A common phenomenon in the world of mutual funds asset bloat, which has corrosive effect on returns.  Bigger the fund size, lesser the returns. Suppose that you have $25 million to invest in the stock. Now you have a very big problem. You will not be able to complete your purchase without dramatically inflating the stock price. Another way of saying this is that at today’s price, there is not nearly enough stock available for sale to meet your needs in order to bring sufficient shares out of the woodwork, the price must be raised. The amount you pay for your shares will be considerably higher than if you had only a small order, and your overall return will be commensurately smaller. The opposite will happen if you decide to sell a large block of stock: you will seriously depress the price, again lowering your return. This decrease in return experienced by large traders is called “impact cost,” and it goes straight to the bottom line of a fund’s return. Unfortunately, it is almost impossible to measure.
• Relatively few of a successful fund’s investors actually get its high early returns. The overwhelming majority hop onto the bandwagon just before it crashes off the side of the road.  A fund with impact cost and high Churn (measured as turnover ratio) severely affects the fund return.
• The straw that struggling investors most frequently grasp at is the hope that they can increase their returns and reduce risk by timing the market —holding stocks when they are going up and selling them before they go down. Sadly, this is an illusion - one that is exploited by the investment industry with bald cynicism.
• It is said that there are only two kinds of investors: those who don’t know where the market is going and those who don’t know that they don’t know. But there is a rather pathetic third kind - the market strategist. These highly visible brokerage house executives are articulate, highly paid, usually attractive, and invariably well-tailored. Their job is to convince the investing public that their firm can divine the market’s moves through a careful analysis of economic, political, and investment data. But at the end of the day, they know only two things: First, like everybody else, they don’t know where the market is headed tomorrow. And second, that their livelihood depends upon appearing to know.
• Noted author, analyst, and money manager David Dreman, in "Contrarian Market Strategy: The Psychology of Stock Market Success", painstakingly tracked opinions of expert market strategists back to 1929 and found that their consensus was mistaken 77% of the time. This is a recurring theme of almost all studies of “consensus” or “expert” opinion; it underperforms the market about three-fourths of the time.
• Noted author Fama had already begun to suspect that stock prices were random and unpredictable, and his statistically rigorous study of the CRSP data confirmed it. But why should stock prices behave randomly? Because all publicly available information, and most privately available information, is already factored into their prices.
• The simple fact that there are so many talented analysts examining stocks guarantees that none of them will have any kind of advantage, since the stock price will nearly instantaneously reflect their collective judgment. In fact, it may be worse than that:
• there is good data to suggest that the collective judgment of experts in many fields is actually more accurate than their separate individual judgments. The concept that all useful information has already been factored into a stock’s price, and that analysis is futile, is known as “The Efficient Market Hypothesis” (EMH).  Although far from perfect, the EMH has withstood a host of challenges from those who think that actively picking stocks has value. There is, in fact, some evidence that the best securities analysts are able to successfully pick stocks. Unfortunately, the profits from this kind of sophisticated stock analysis are cut short by impact costs as described above.
• In the aggregate, the benefits of stock research do not pay for its cost. The Value Line ranking system is a perfect example of this. Most academics who have studied the system are impressed with its theoretical results, but, because of the above factors, it is not possible to use its stock picks to earn excess profits. By the time the latest issue has hit your mailbox or the library, it’s too late. In fact, not even Value Line itself can seem to make the system work; its flagship Value Line Fund has trailed the S&P 500 by 2.21% over the past 15 years. Only 0.8% of this gap is accounted for by the fund’s expenses. If Value Line cannot make its system work, what makes you think that you can beat the market by reading the newsletter four days after it has left the presses?
• There’s yet another dimension to this problem that most small investors are completely unaware of: you only make money trading stocks when you know more than those on the other side of your trades. The problem is that you almost never know who those people are. If you could, you would find out that they have names like Fidelity, PIMCO, or Goldman Sachs. It’s like a game of tennis in which the players on the other side of the net are invisible. The bad news is that most of the time, it’s the Williams sisters.
• It never ceases to amaze me that small investors think that by paying $225 for a newsletter, logging onto Yahoo!, or following a few simple stock selection rules, they can beat the market. Such behavior is the investment equivalent of going up against the Sixth Fleet in a rowboat, and the results are just as predictable.
• Any discussion about the failure of professional asset management is not complete until someone from the back of the room triumphantly raises his hand and asks, “What about Warren Buffett and Peter Lynch?” 
• In the first place, Berkshire is not exactly a risk-free investment. For the one-year period ending in mid-March of 2000, the stock lost almost half its value, compared to a gain of 12% for the market. Second, with its increasing size, Buffett’s pace has slowed a bit. Over the past four years, he has beaten the market by less than 4% per year. Third, and most important, Mr. Buffett is not, strictly speaking, an investment manager, he is a businessman. The companies he acquires are not passively held in a traditional portfolio; he becomes an active part of their management.
• Yes, Lynch and Buffett are skilled. But these two exceptions do not disprove the efficient market hypothesis. The salient observation is that, of the tens of thousands of money managers who have practiced their craft during the past few decades, only two showed indisputable evidence of skill. Our eyes settle on Buffett and Lynch only in retrospect. The odd of picking these two out of the pullulating crowd of fund managers ahead of time is NIL.
• It’s bad enough that mutual-fund manager performance does not persist and that the return of stock picking is zero. This is as it should be, of course. These guys are the market, and there is no way that they can all perform above the mean.
• Most investors think that the fund’s expense ratio (ER) listed in the prospectus and annual reports is the true cost of fund ownership. Wrong. There are actually three more layers of expense beyond the ER, which only comprises the fund’s advisory fees (what the chimps get paid) and administrative expenses. The next layer of fees is the commissions paid on transactions. These are not included in the ER, but since 1996 the SEC has required that they be reported to shareholders. However, they are presented in the funds’ annual reports in such an obscure manner that unless you have an accounting degree, it is impossible to calculate how much return is lost as a percentage of fund assets.
• The second extra layer of expense is the bid/ask “spread” of stocks bought and sold. A stock is always bought at a slightly higher price than its selling price, to provide the “market maker” with a profit. (Most financial markets require a market maker—someone who brings together buyers and sellers, and who maintains a supply of securities for ready sale to ensure smooth market function. The bid/ask spread induces organizations to provide this vital service.) This spread is about 0.4% for the largest, most liquid companies, and increases with decreasing company size. For the smallest stocks it may be as large as 10%. It is in the range of 1% to 4% for foreign stocks.
• The last layer of extra expense - market impact costs, is the most difficult to estimate. Impact costs are not a problem for small investors buying shares of individual companies but are a real headache for mutual funds. Obviously, the magnitude of impact costs depends on the size of the fund, the size of the company, and the total amount transacted.
• The average net return to investors is generally the market return minus the expense of active stock selection.

Index Fund – Investing Nirvana

• One of the professionals surveying the scene in the late 1960s was a young man named William Fouse. Excited by the new techniques of portfolio evaluation, he began evaluating the performance of his colleagues at his employer, Mellon Bank. He was aghast - none of those money managers came even close to beating the market. The solution was obvious to Mr. Fouse; create a fund that would buy all the stocks in the S&P 500 Index. This could be done with a minimum of expense and was guaranteed to produce very close to the market return. But his idea was not welcomed by his employer and soon he landed a new job at Wells Fargo.
• In 1971, Wells Fargo founded the first index fund. It was an unmitigated disaster. Instead of using Fouse’s original S&P 500 idea, they decided to hold an equal dollar amount of all 1,500 stocks on the New York Stock Exchange. Since the stock price of its companies often moved in radically different directions, this required almost constant buying and selling to keep the values of each position equal. This, in turn, resulted in expenses equal to that of an actively managed fund. It was not until 1973 that Fouse’s original idea, a fund that held all of the stocks in the S&P 500 in proportion to their market value (and thus did not need rebalancing), was adopted.
• Wells Fargo’s index fund was not initially available to the general public, but that was soon to change. A few years later, in September 1976, John Bogle’s young Vanguard Group offered the first publicly available S&P 500 Index fund.
• An Index Fund refers to a fund that owns all, or nearly all, of the stocks in a given index, with no attempt to pick those with superior performance. Less commonly, it refers to a fund that holds all stocks meeting certain rigid criteria, usually having to do with market size or growth/value characteristics, such as price-to-book ratio. Today, almost all index funds are “cap weighted.” This means that if the value of a stock doubles or falls by half, its proportional contribution in the index does as well, so it is not necessary to buy or sell any to keep things in balance. Thus, as long as the stocks remain in the index, it is not necessary to buy or sell stocks because of changes in market value. If the case I’ve presented for indexing is not powerful enough for you, then consider the effect of taxes. Active funds generate more unnecessary capital gains and resultant taxes.
• You may ask, “If the markets are efficient, why can’t I simply buy and hold my own stocks? That way, I’ll never sell them and incur capital gains as I would when an index occasionally changes its composition, forcing capital gains in the index funds that track it. And since I’ll never trade, my expenses will be even lower than an index fund’s.”
• There is an important reason why you should not attempt to build your own portfolio of stocks, and that is the risk of buying the wrong ones. You may have heard that you can obtain adequate diversification by holding as few as 15 stocks. This is true only in terms of lowering short-term volatility. But the biggest danger facing your portfolio is not short-term volatility—it’s the danger that your portfolio will have low long-term returns. if you own all the stocks in the market, you will always get the market return, with no risk of failing to obtain it. Obviously, a concentrated portfolio maximizes your chance of a superb result. Unfortunately, at the same time, it also maximizes your chance of a poor result. In other words, concentrating your portfolio in a few stocks maximizes your chances of getting rich. Unfortunately, it also maximizes your chance of becoming poor. Owning the whole market—indexing - minimizes your chances of both outcomes by guaranteeing you the market return.

Allegations on Index Fund

• “Active managers do better than index funds in down markets.”  This is flat-out wrong—they certainly do not. See the downfall history of markets and you will conclude this downside protection in active funds is bullshit.
• “Indexing works fine for large stocks, but in the less efficient small-cap market, active analysis pays off.”  There is no valid proof for this. There are cycles when small cap outperform large caps and then the cycle reverses. Even if it is possible for active managers to successfully pick small stocks, transactional costs in this arena are much higher than with large stocks, so any gains from stock picking will be more than offset by the costs of trading small stocks.
• “An index fund dooms you to mediocrity.” Absolutely not: it virtually guarantees you superior performance. Over the typical ten-year period, most money managers would kill for index-matching returns.
• “You will never have exceptional returns; you will never get fabulously rich.” This is legitimate criticism that can be leveled at an indexing strategy:  As we’ve already discussed, poorly diversified strategies do indeed maximize your chances of winding up with bags of money. Unfortunately, they also maximize your chances of ending your days in a trailer park. Again that’s your own choice; no one else can make it for you.

Asset Allocation

• Since you cannot successfully time the market or select individual stocks, asset allocation should be the major focus of your investment strategy, because it is the only factor affecting your investment risk and return that you can control.
• The key is to ignore the year-to-year relative performance of the individual asset classes—their behavior usually averages out over the years—it is the long-term behavior of your whole portfolio that matters, not its day-to-day variation.
• If you are just starting out on your investment journey, err on the side of conservatism. Millions of investors in the 1920s and 1960s thought that they could tolerate a high exposure to stocks. In both cases, the crashes that followed drove most of them from the equity markets for almost a generation. Since the risk of your portfolio is directly related to the percentage of stocks held, it is better that you begin your investment career with a relatively small percentage of stocks.
• This flies directly in the face of one of the prime tenets of financial planning conventional wisdom: that young investors should invest aggressively, since they have decades to make up their losses. The problem with an early aggressive strategy is that you cannot make up your losses if you permanently flee the stock market because of them.
• Have global diversification. Why diversify abroad? Because foreign stocks often zig when domestic markets zag, or at least may not zig as much.
• There can be no question that small stocks are riskier than large stocks. Small companies tend to be insubstantial and fragile. More importantly, they are thinly traded—relatively few shares change hands during an average day, and in a general downturn, a few motivated sellers can dramatically lower prices.

Market Boom & Bust

• About once every generation, the markets go barking mad. When this happens, most investors sustain serious damage, many are totally ruined. Markets can crash, but it is less well known that markets can also become depressed for decades at a time. There are periods of euphoria and there are periods of depression that occur on a fairly regular basis. The average investor lives through at least a few markets of both types.
• Of the four key areas of investment knowledge - theory, history, psychology, and investment industry practices - the lack of historical knowledge is the one that causes the most damage.
• A knowledge of history is not essential in many fields. You can be a superb physician, accountant, or engineer and not know a thing about the origins and development of your craft. There are also professions where it is essential, like diplomacy, law, and military service. But in no field is a grasp of the past as fundamental to success as in finance.
• Academics love to argue whether the primary historical driving forces over the ages are repetitive and cyclical or non-repetitive and progressive. But in finance, there is no controversy: the same speculative follies play out with almost clock-like regularity about once a generation.
• Manifestly, technological progress drives economic progress, which in turn drives stock prices. Should some malign force suddenly stop all scientific and technological innovation, then our standard of living would remain frozen at the present level; corporate profits would remain stationary and stock prices, although fluctuating as they always have, would not experience any long-term rise. This point cannot be made forcefully enough: the great engine of stock returns is the rate of technological progress, not its absolute level.
• We tend to think of technological progress as an ever-accelerating affair, but it just isn’t so. Technological innovation comes in intense spurts. And the most impressive blooms were not at all recent. If you want to see the full force of scientific progress on human affairs, you have to go back almost two centuries. The technological explosion that occurred from 1820 to 1850 was undoubtedly the deepest and far reaching in human history, profoundly affecting the lives of those from the top to the bottom of the social fabric, in ways that can hardly be imagined today. Within a brief period, the speed of transportation increased tenfold (invention of steam engine), and communications became almost instantaneous (with telegram). In the world of 1801, nothing moved faster than the speed of a horse. Information traveled as slowly as physical goods. With the invention of the telegraph by Cooke and Wheatstone in 1837, instantaneous telegraphy abruptly changed the face of economic, military, and political affairs. 
• But that does not mean that the economic and financial effects of technological revolutions occur immediately. Not at all. The steam and internal combustion engines did not completely displace horses in the transport of bulk goods for nearly a century, and it took several decades for computers to travel from the laboratory into the office, and, finally, into the home. Immediately after their invention, the telegraph and telephone were the toys and tools of the wealthy. Ordinary people did not begin to routinely make long-distance calls until relatively recently.
• The United States and Britain have been at the forefront of world technological progress for the past two centuries. What you are looking at is its flesh-and-blood track; it is also the engine of increasing stock prices.
• When you and I purchase shares of stock or a mutual fund, according to strict economic definition, we are not investing. After all, the money we pay for our shares does not go to the companies, but, instead, to the previous owner of the shares. In economic terms, we are not investing; we are saving. (And, contrary to popular opinion, the overall economic effect of saving is often negative.) Only when we purchase shares at a so-called “initial public offering” (IPO) are we actually providing capital for the acquisition of personnel, plant, and equipment. Only then are we truly investing. Most of the time, we are buying and selling shares in the “secondary market”; the company usually has no interest in the flow of funds, since such activity does not directly impact it.
• But the returns on “real investing”—that is, the purchase of IPOs—are ghastly. IPO investors thus deserve an honored place in our economic system — they are capitalism’s unsung, if unwitting, philanthropists, bearing poor returns so that the rest of us may prosper.
• Whatever the underlying conditions, bubbles occur whenever investors begin buying stocks simply because they have been going up. This process feeds on itself, like a bonfire, until all the fuel is exhausted, and it finally collapses. Most bubbles are like Shakespeare’s dramas and comedies: the costumes, dialect, and historical setting may be foreign, but the plot line and evocation of human frailty are intimately familiar to even the most casual observer of human nature.