“Few people understood the disconnect between what the market should do and what it actually does better than one of the most infamous names in all of finance, John Maynard Keynes.”
Michael Batnick led into chapter 13 of “Big Mistakes: The Best Investors and Their Worst Investments” with a brief exposition on the futility of trying to master the stock market. He wrote:
“Even if we had tomorrow's news today, we couldn't know how markets would react because the laws of physics do not govern them. There is no E = MC2. If you drop an eight”sided ball, there's no way to predict which way it would bounce. The same idea holds true in finance – Serotonin plus adrenaline plus different time horizons times a few million participants equals literally nobody knows.”
John Maynard Keynes, the giant of 20th century economics and holder of a giant ego, thought he was smart enough to be the exception to that rule. And why not? Batnick noted he was the author of a number of best-selling finance books, a man who had revolutionized institutional asset management and “practically built the global monetary system as we know it.”
He was widely known and praised for foreseeing that the crippling penalties imposed on Germany after World War I would lead to another war. An obituary in The New York Times, cited by Batnick, read, “To find an economist of comparable influence, one would have to go back to Adam Smith.”
But Keynes, like many of us, wandered in the financial wilderness for years before becoming an investment genius. He began by speculating in currencies, with big bets on the French franc and German Reichsmark, shorting both because he expected them to be hurt by post-war inflation. That was successful and netted him $30,000 in 1920 dollars in just a few months.
With that he next founded a syndicate that would manage the investments of friends and family. That started well, but a brief uptick in economic confidence ran over his shorted currencies and wiped out all the capital in the syndicate. His father had to rescue Keynes, but he continued to speculate and by the end of 1922 had built up the equivalent of $2 million in 2018 dollars.
Using the same top-down approach, Keynes then moved into commodity speculation, thinking that tin, cotton and wheat would less volatile than currencies. Batnick reported that it is difficult to know how well he did in this arena because he had such a high rate of turnover. He wrote, “He suffered like I did and so many other investors do, from the illusion of control. He thought that by trading so frequently, he could control his own destiny and achieve success. He was wrong.”
He also took control of the finances at King’s College, Cambridge in 1924, and used the same top-down approach as with his other ventures. He underperformed, even while convincing the college to change its asset allocation strategy. Previously, it had stuck to real estate and bonds; stocks were too risky for it. Keynes persuaded them to give him a piece of the fund for investments in the stock market.
When the world economy crashed in 1929, he was caught. Batnick wrote, “Keynes thought he would fare better speculating in an asset [stocks] that had daily price quotes and liquidity than investing in something over which he had little control. But he was highly levered when the crash came, and the belief that his ability to track credit cycles and economic expansions and contractions had failed him.”
The fund fell 32% in 1929 and 24% in 1930. In addition, the investment pool he was running at the time failed and had to be liquidated. Batnick quoted John F. Wasik (who wrote "Keynes's Way to Wealth: Timeless Investment Lessons from The Great Economist"):
“Although Keynes was well known for his arrogance and his air of intellectual superiority, the humbling experience of having nearly lost two fortunes changed his thinking on the best way to invest.”
According to Batnick, “Keynes did a complete 180, shifting his thinking from being a short-term speculator to a long-term investor.” And so he began doing fundamental analyses of the companies in which he was interested, giving special attention to those selling for less than their intrinsic value.
“Keynes went from macro to micro, top down to bottom up, and with this new vision, he was able to build a fortune for himself, King's College, and two insurance companies. Keynes put his ego to the side and gave up trying to forecast interest rates and currencies and how they affect the economy. As a long”term value investor, he bought 'Securities where I am satisfied as to assets and to ultimate earning power and where the market price seems cheap in relation to these.'”
In fact, Keynes wrote about the advantages of buying for less than intrinsic value in chapter 12 of “The General Theory of Employment, Interest, and Money.” Still, his conversion wasn’t entirely successful; between 1936 and 1938, he lost two-thirds of his own wealth and lost money for King’s College and the two insurance companies for which he was managing money.
King’s demanded an explanation. In reply, Keynes listed three critical principles:
- Stock investments should be made when they are cheap in relation to their intrinsic value.
- These purchases should be held “through thick and thin, perhaps for several years, until they have fulfilled their promise or it is evident that they were purchased on a mistake.”
- Having a balanced investment position, for risk management purposes.
In later writings, Keynes came to describe short-term thinking as “animal spirits,” a phrase that lives on. Batnick wrote, admiringly, “Keynes is one of the rare investors that was not only aware of his cognitive biases but was able to effectively combat them.”
And in the end, Keynes did become an investing legend, a guru. Between 1932 and 1945, he grew the King’s College Fund by a whopping 869%, while the British market grew only 23% over the same period. This was a period that included not only the Great Depression, but also all of World War II.
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