When beggars and shoeshine boys, barbers and beauticians can tell you how to get rich, it is time to remind yourself that there is no more dan-
gerous illusion than the belief that one can get something for nothing.
—Bernard BaruCh
E
arly in my teaching career, a student named Jon told me about an exciting investment he was making. All through high school he had been collecting postage-stamp plate blocks. At the time, stamps were printed fifty stamps to a sheet and a plate block was the four stamps in a two-by-two block next to the sheet’s serial number.Plate blocks were rare because no one had ever thought to save them. Then, unexpectedly, plate blocks became a collectible. Prices rose rapidly and Jon joined others in the gold rush. Every time a new stamp came out, Jon went to his local post office and bought several plate blocks. Sometimes, he bought complete fifty-stamp sheets in case these, too, became collectible. He kept his stamps in mint con- dition by storing them in protective plastic sleeves in binders. He proudly told me that he had several thousand dollars “invested.”
I told Jon that this was speculation, not investing, because his stamps didn’t generate any income. Jon insisted that it was an in- vestment because prices had been going up. Indeed, the plate-block market was doing better than the stock market. Seeing that I was getting nowhere, I said, “Twenty years from now, let me know how it works out.”
Roughly twenty years later I got a large envelope in the mail from Jon. He told me about his career as a portfolio manager and thanked me for the class he had taken from me. The postage on the envelope consisted of dozens of stamps, shown in Figure 5-1. The plate-block market had collapsed and this was Jon’s way of saying that I was right.
When Jon tried to liquidate his stamp collection, dealers offered him $9 for every $10 of face value. Nobody wanted to buy the stamps for anything other than mailing letters and dealers didn’t want to tie their money up in inventory that wasn’t moving. Jon was stubborn, so he kept his stamps and was liquidating his collection letter by letter.
FIGURE 5-1. The risks of speculation
Baseball cards are another collectible. For many years, baseball cards were advertising giveaways or sold with cigars, cigarettes, and bub- ble gum. Children traded cards, played games with them, and stuck them in their bicycle spokes to make motorcycle sounds. Then grown-ups decided that baseball cards were a collectible, too valu- able to be touched, let alone played with. They were convinced that they could get rich buying baseball cards for pennies and selling them a few years later for dollars.
Eventually, the market for new cards crashed. However, old cards are still considered valuable—simply because they are rare. In 2007 a collector paid $2.8 million for a 1909 Honus Wagner card that had originally been included in a cigarette pack. Wagner reportedly did not smoke and asked the company not to distribute the cards be- cause he did not want children to buy cigarettes. Only about 200 cards were printed and, of these, only fifty or so were distributed. At the time of the 2007 auction, it was thought that only three cards had survived, but more have since surfaced.
Does this card’s rarity make it worth millions of dollars? No.
Baseball cards have no intrinsic value because they generate no cash whatsoever. Yet some people believe that rare cards have value because they are rare. It’s sort of like people being famous for being famous. There is no rational explanation. Rarity does not make something valuable.
A former student sent me a collection of cards that are rarer than baseball cards that are thought to be worth thousands of dollars.
These are economics trading cards distributed by the economics club at the University of Michigan, Flint. Each card has a picture of a famous economist on the front and some lifetime statistics on the back. The James Tobin card (see Figure 5-2) says he was born in Champaign, Illinois, in 1918, and received his bachelor’s degree and PhD from Harvard in 1939 and 1947 (interrupted by military duty during World War II).
FIGURE 5-2. James Tobin trading card
There is a summary of his research and a memorable quotation:
I studied economics and made it my career for two reasons.
The subject was and is intellectually fascinating and chal- lenging, particularly to someone with taste and talent for theoretical reasoning and quantitative analysis. At the same time it offered the hope, as it still does, that improved un- derstanding could better the lot of mankind.
If you are interested, make me an offer. Remember, this card is VERY rare.
Some people believe in the Latin saying, Res tantum valet quantum vendi potest: A thing is worth only what someone else will pay for it.
That’s like many of the quotations attributed to former baseball player and manager Yogi Berra; for example, “It’s not over until it’s over.” It is literally true, but so circular as to be meaningless. Yes, something is worth what someone is willing to pay for it, if by
“worth” you mean the price people pay is the price they are willing to pay. Investors think differently. As John Burr Williams said, “A stock is worth only what you can get out of it.”
What do you get out of looking at a postage stamp or a baseball card or any other so-called collectible? A collector who paid $250,000 for an early Batman comic explained that he keeps the comic in an airtight bag in a bank vault: “I’ve been toying with the idea of read- ing it, but I haven’t yet.”
B E A NI E B A B I E S
Beanie Babies are stuffed animals with a heart-shaped hang tag. The beanie name refers to the fact that these toys are filled with plastic pellets (“beans”). Around 1995, the same time the dot-com bubble was inflating, Beanie Babies came to be viewed as collectibles be- cause buyers expected to profit from escalating Beanie Baby prices by selling these silly bears to an endless supply of greater fools.
Delusional grown-ups stockpiled Beanie Babies, thinking that they would pay for their retirement or their kids’ college education. Ah, good plan.
What is the intrinsic value of a Beanie Baby? It doesn’t pay divi- dends. It doesn’t pay anything! You can’t even play with a Beanie Baby. To preserve its value as a collectible, a Beanie Baby must be stored in an airtight containers in a cool, dark, smoke-free environ- ment. Yet the hopeful and the greedy paid hundreds of dollars for Beanie Babies that originally sold in toy stores for a few dollars.
They saw how much prices had increased in the past and assumed the same would be true in the future. They had no reason for believ- ing this, but they wanted to believe.
Figure 5-3 shows the Princess Beanie Baby honoring Diana, the Princess of Wales. The Princess sold for $500 in 2000. Then the bubble popped. I bought this bear on the internet in 2008. The shipping cost more than the bear.
FIGURE 5-3. Is this Beanie Baby worth $500?
PO N Z I S C H E M E S
If you mail a letter to a person in another country, you can enclose an international reply coupon that can be exchanged for postage stamps in that country and used to mail a letter back to you. It is like enclosing a self-addressed stamped envelope, but gets around the problem of the sender having to buy foreign postage stamps. It is the polite thing to do, but also the source of the most famous swin- dle in history.
In 1920, a Massachusetts man named Charles Ponzi promised to pay investors 50 percent interest every forty-five days. Compounded eight times a year, the effective annual rate of return would be 2,463 percent! He said that his profits would come from taking advantage of the difference between the official and open market price of Spanish pesos. He would buy Spanish pesos cheap in the open mar- ket, use these pesos to buy international reply coupons, and then trade these coupons for U.S. postage stamps at the higher official ex- change rate. If everything worked as planned, he could buy 10 cents’
worth of U.S. postage stamps for a penny. (It was not clear how he would convert these stamps into cash.) In practice, he received $15 million from investors and appears to have bought only $61 in stamps.
If he didn’t invest any money, how could he afford to pay a 50 percent return every forty-five days? He couldn’t. But he could cre- ate a temporary illusion of doing so. Suppose that a person invests
$100, which Ponzi spends on himself. If Ponzi now finds two peo- ple to invest $100 apiece, he can give the first person $150, and keep $50 for himself. Now, he has forty-five days to find four peo- ple willing to invest $100 so that he can pay each of the two previ- ous investors $150 and spend $100 on himself. These four can be paid with the money from eight new investors, and these eight from sixteen more.
TH E FA L L A C Y
Ponzi’s legacy is the Ponzi scheme. In a Ponzi scheme, money from new investors is paid to earlier ones, and it works as long as there are enough new investors. The problem is that the pool of fish is ex- hausted surprisingly soon. The twenty-first round requires a million new people and the thirtieth round requires a billion more. At some point, the scheme runs out of new people and those in the last round (the majority of the investors) are left with nothing. A Ponzi scheme merely transfers wealth from late entrants to early entrants (and to the person running the scam).
Ponzi’s scam collapsed after eight months when a Boston news- paper discovered that during the time that he supposedly bought
$15 million in postage coupons, the total amount sold worldwide came to only $1 million. Ponzi promised that he could pay off his in- vestors by starting a company and selling stock to other investors.
Massachusetts officials were unpersuaded. They sent Ponzi to jail for ten years.
A Ponzi scheme is also called a pyramid deal, since its workings can be visualized by imagining a pyramid with the initial investors at the top and the most recent round on the bottom; the pyramid col- lapses when the next round doesn’t materialize. Even though it seems obvious that no one will make money unless others lose money, greed blinds participants to the likelihood that they will be among the losers.
IN VE S TM E N TS TH AT W ERE TOO G OO D TO B E TRUE
Ponzi schemes are illegal frauds, but they usually disguise their true nature by promising to channel investors’ money to a unique invest- ment or to a fabulous money manager. Our best protection is sober reflection and common sense. If it looks too good to be true, it
probably isn’t true. But greed is a powerful emotion and often tram- ples common sense. One of the most notorious cases involved Ber- nie Madoff.
For more than a decade, Madoff told investors—many of them Jewish charitable organizations—that he was earning double-digit returns year after year using a “split-strike conversion” strategy that involves buying stock and put options and writing call options. This is actually a conservative strategy that is unlikely to generate double- digit returns. Perhaps even more suspiciously, Madoff reported neg- ative returns in only seven months over a fourteen-year period.
Skeptics looked at the ups and downs in the S&P and concluded that Madoff’s performance claims were mathematically impossible.
To true believers, this added to his mystique. One of his clients raved, “Even knowledgeable people can’t really tell you what he’s doing.”
What he was doing was running a Ponzi scheme, the largest ever.
In December 2008, Madoff was having severe liquidity problems and confessed to his sons that it was “one big lie,” a Ponzi scheme that was collapsing. His sons reported his confession to the govern- ment. Madoff was arrested and, four months later, pleaded guilty to eleven felonies. He admitted that he had not made any real invest- ments for nearly two decades and that there was a $65 billion short- fall between what his clients thought they had in their accounts and what they actually had. Once the lawyers had been paid, investors got back $10 billion less than their original investment.
Madoff was sentenced to 150 years in prison and sent to a federal facility in North Carolina. He told a relative, “It’s much safer here than walking the streets of New York.”
SPECULATIV E B UB B L E S A ND PA NI CS From time to time, investors are gripped by what, in retrospect, seems to have been mass hysteria. The price of something climbs
higher and higher, beyond all reason, but it’s a speculative bubble because nothing justifies the rising price except the hope that it will go higher still. Then, suddenly, the bubble pops, buyers vanish, and the price collapses. With hindsight, it is hard to see how people could have been so foolish and paid such crazy prices. Yet, at the time of the bubble, it seems foolish to sit on the sidelines while oth- ers become rich.
Some people, including Nobel laureate Eugene Fama, do not think that bubbles can even occur. They argue that since markets al- ways set the correct prices, whatever prices those markets set must be correct.
It is hard to take this circular argument seriously if we define a bubble as a situation in which the price cannot be justified by an as- set’s intrinsic value, but is instead propelled by a belief that the price will keep rising. When a Beanie Baby sold for $500, was that not a bubble? What rational explanation are we overlooking?
In 2013 Fama accepted that a bubble is “an extended period dur- ing which asset prices depart quite significantly from economic fun- damentals.” Yet, he danced around this definition when he argued the following:
The word “bubble” drives me nuts, frankly, because I don’t think there’s anything in the statistical evidence that says anybody can reliably predict when prices go down. So if you interpret the word “bubble” to mean I can predict when prices are going to go down, you can’t do it. . . .
I believe markets work. And if markets work those things shouldn’t be predictable. If I can predict that housing prices will go down, if the market’s working properly, they should go down now. . . . If the market’s working properly, the infor- mation should be in the prices.
The argument that prices sometimes go far above intrinsic value does not require that we know when prices will crash. Indeed, the essence of a bubble is that people do not know when it will pop.
Fama is correct in arguing that if people know that prices will go down tomorrow, prices will go down today. But he is wrong in argu- ing that bubbles must be predictable. And he is wrong in arguing that the fact that price changes are hard to predict proves that prices are always equal to intrinsic values. Price changes might be hard to predict because they are swayed by irrational, unpredictable emotions.
TH E SO U TH S E A BUBBL E
In 1720, the British government gave the South Sea Company exclu- sive trading privileges with Spain’s American colonies. None of the company’s directors had ever been to America, nor had they any concrete plans to trade anything. Nonetheless, encouraged by the company’s inventive bookkeeping, English citizens rushed to invest in this exotic venture. As the price of the South Sea Company’s stock soared from £120 on January 28 to £400 on May 19, then £800 on June 4, and £1,000 on June 22, some people became rich and thousands rushed to join their ranks. It was said that you could buy South Sea stock as you entered Garraway’s coffeehouse and sell it for a profit on the way out.
Soon con men were offering stock in even more grandiose schemes and were deluged by frantic investors not wanting to be left out. It scarcely mattered what the scheme was. One promised to build a wheel for perpetual motion. Another was formed “for carry- ing on an undertaking of great advantage, but nobody is to know what it is.” The shares for this mysterious offering were priced at
£100 each, with a promised annual return of £100; after selling all of the stock in less than five hours, the promoter left England and never returned. Yet another stock offer was for the “nitvender” or selling of nothing. Yet, nitwits bought nitvenders. When the South Sea Bubble burst, fortunes and dreams disappeared.
As with all speculative bubbles, there were many believers in the
Greater Fool Theory. While some suspected that prices were unrea- sonable, the market was dominated by people believing that prices would continue to rise, at least until they could sell to the next fool in line. In the spring of 1720, Sir Isaac Newton said, “I can calculate the motions of the heavenly bodies, but not the madness of people,”
and sold his South Sea shares for a £7,000 profit. But later that year, he bought shares again, just before the bubble burst, and lost
£20,000. When a banker invested £500 in the third offering of South Sea stock, he explained that “when the rest of the world are mad, we must imitate them in some measure.” After James Milner, a member of the British Parliament, was bankrupted by the South Sea Bubble, he explained that “I said, indeed, that ruin must soon come upon us but . . . it came two months sooner than I expected.”
Yes, no one knows for certain when a bubble will pop, but that does not mean that a bubble is not a bubble. The price of nitvender stock was no more related to economic fundamentals than was the price of the Princess Beanie Baby.
TH E DO T-C OM B U BBLE
It is hard to imagine life without the internet—without email, Google, and Wikipedia at our fingertips. When the electricity goes out or we go on vacation, internet withdrawal pains can be over- whelming. Cell phones only heighten our addiction. Do we really need to be online and on call 24/7? Must we respond immediately to every email, text, and tweet? Do we really need to know what our friends are eating for lunch? Apparently we do.
Back in the 1990s, when computers and cell phones were just starting to take over our lives, the spread of the internet sparked the creation of hundreds of online companies, popularly known as dot- coms. Some dot-coms had good ideas and matured into strong, suc- cessful companies. But many did not. In too many cases, the idea was simply to start a company with a dot-com in its name, sell it to