Keynes on Investment, Speculation and Uncertainty Part II

In the first part of this series (duo?) we began looking at Chapter 12 from John Maynard Keynes' General Theory. Today we will finish that discussion a bit.

In the first part we looked at the role uncertainty has in investment. In particular, Keynes notes that there is great difficulty in predicting future variables regarding investment opportunities. As a result we mainly rely on the convention that the future will, more or less, behave like the recent past.

In this part we'll be looking at a distinction Keynes makes between enterprise and speculation. Keynes gives the following definitions:

enterprise:

the activity of forecasting the prospective yield of assets over their whole life

speculation:

the activity of forecasting the psychology of the market

In the case of enterprise we are concerned with what sort of cash flows that a particular asset can generate and pay a price appropriate to that. In the case of speculation, we are trying to see what market participants will think of an asset, in the near future.

Keynes relates this to a focus on whether one is investing, like the English do, "for income" or as the American does, for "capital appreciation". In the case of the latter, the concern is not so much with what the investment is really worth (via its yield) but what other investors will be willing to pay for it in the near future (to wit, "market psychology").

Keynes' Prettiest Face Contest

Regarding speculation, Keynes uses the following oft-quoted metaphor:

professional investment [which he considers speculation] 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.

Figure 1: Do you think I would win this prettiest face contest?

Montier's Prettiest Number Contest

James Montier reproduced a game analogous to Keynes' prettiest face contest in an article called Six Impossible Things before Breakfast.

This game can be easily replicated by asking people to pick a number between 0 and 100, and telling them the winner will be the person who picks the number closest to two-thirds the average number picked.

Over 1000 professional investors played the game in his study. The result was the average number was 26. Two-thirds of that is 17. Only 3 out of over 1000 picked the correct answer. Montier also offered some interesting analysis for why some of the commonly selected numbers were selected.

The problem with speculation

I think this is worth quoting verbatim:

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.

It's not too hard to think of examples of this such as the recent housing bubble or the dotcom bubble of the late 90's. Speculators dumped plenty of capital without much consideration for the prospective yield of the asset, concerning themselves only whether or not they will be able to flip the asset for a profit in the short term. The result was poorly allocated capital. (On the plus side, the dotcom bubble did do a lot to advance the internet, which may be seen as a good thing.)

Keynes proposed solution to speculation

So Keynes actually has a proposed solution to the speculative element in capital markets which has been echoed by many investors as a good investment principle:

The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only.

One application of this is The Coffee Can Portfolio as discussed by Robert Kirby. Kirby notes that the idea goes by to the Old West:

when people put their valuable possessions in a coffee can and kept it under the mattress. (Kirby 1984).

The idea is simple: do thorough research when making selections and hold for the long term.

The downside to this, as Keynes notes, is that it would kill the liquidity of the markets and he sees that liquidity as one of its valuable features as it "often facilitates [ . . . ] the course of new investment".

Concluding Remarks

The overall theme of the chapter is that investment, proper, is about considering what cash flows (what Keynes called "prospective yield") an asset can produce and allocating capital accordingly. This focus creates more functional capital markets.

On the other hand, speculation is concerned with allocating capital to those assets that they expect others will be willing to pay a higher price for in the future (nowadays referred to as the "greater fool theory") and to profit from that capital appreciation.

The problem is that investment is not an easy task, attempting to project future cash flows under conditions of uncertainty. This makes speculation somewhat appealing as it may seem easier to project future market opinion than it is future business conditions and the short-term profits may seem worth it.

But I think focusing on investment will do capital markets (and our own personal finances) much good.

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