[Monti]

The Inefficiency of financial Markets According to J.M. KeynesThe Efficient Markets Hypothesis plays an important role in the neoclassical theory that dominates political economy. The initiators of its modern expression are William Sharpe (1964) and Eugene Fama (1970). This hypothesis states that stock markets tend to value securities at the right price. Consequently, it is not possible to increase the return of a portfolio without taking more risk. What does the greatest economist in history think of that question?

In the General Theory of Employment, Interest, and Money, which revolutionised macroeconomics in 1936, Keynes devotes Chapter 12 "The State of Long-term Expectation" to the stock market. Here are some excerpts from this chapter. The numbers in parentheses refer to the page number in the edition of First Harvest/Harcourt (1964).

A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield; since there will be no strong roots of conviction to hold it steady. In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual even though there are no express grounds to anticipate a definite change, the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation (154).

But there is one feature in particular which deserves our attention. It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it 'for keeps', but with what the market will value it at, under the influence of mass psychology, three months or a year hence (154).

Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs—a pastime in which he is victor who says Snap neither too soon nor too late, who passed the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated (155-156).

Or, to change the metaphor slightly, professional investment 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 (156).

If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investments on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets (156-157).

If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase. In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market. It is rare, one is told, for an American to invest, as many Englishmen still do, 'for income'; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that, when he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation, i.e. that he is, in the above sense, a speculator. 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. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism—which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object (158-159).

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. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment (160).

Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die;—though fears of loss may have a basis no more reasonable than hopes of profit had before (161-162).

We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance (162-163).

Decisions of buying or selling are taken on basis of the deviation between the market price and the assumed right price. But this last one is influenced by the fluctuations of the market price and this influence is destabilising.

[quetzalcoatl]

Keynes seems to be foreshadowing Minsky's financial instability hypothesis. He appears to identify financial liquidity (operating in conjunction with human psychology) as the underlying structural cause, whereas Minsky looked more at succeeding cycles of boom and bust concentrating investment into the financial sector.

[Monti]

Keynes seems to be foreshadowing Minsky's financial instability hypothesis. He appears to identify financial liquidity (operating in conjunction with human psychology) as the underlying structural cause, whereas Minsky looked more at succeeding cycles of boom and bust concentrating investment into the financial sector.

There are many books or articles written by economists who have read articles written by economists who have read articles written by economists who have read articles written by... an economist who has read "The General Theory". All these people think that Keynes has only considered short term questions. They should read this book, the reading of which is impressive, exciting and... very easy.

[Puffer Fish]

It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it 'for keeps', but with what the market will value it at, under the influence of mass psychology, three months or a year hence (154).

There is an element of truth to this yes, but ultimately, in the long term, in a very indirect sort of fashion, it does come down to what it is worth to the man who buys it 'for keeps'.

The majority of investors, in terms of volume of stocks purchased, are professionals.

Public psychology certainly is one element to it, and a big one, since especially big profits can be made off that psychology. When the masses are acting irrationally and emotionally, and some of the professionals know that.

No one is forcing the "stupid" people to sell their stocks for cheap.

If you're trying to make some point that these speculator investors are parasites, there are some free market arguments that argue this does indeed serve a useful purpose.
You might see my thread about "Scalping goods during a panic - price gouging serves a functional purpose"
viewtopic.php?f=9&t=180531

[Monti]

According to Keynes- and I think he is right-, uncertainty is much stronger than according to neoclassical economics. So Keynes's definition of uncertainty -"we simply do not know"- applies to professional traders as for the masses. Economic history, for example the crisis of 2007-2009 shows that professional's expectations are not so rarely wrong . Economic crises are regularly preceded by a speculative bubble. Professional traders are not less responsible than amateurs.
Expectations are influenced by the opportunity of gains. Not to buy or not to sell could let you see a good gain that goes away. That is true for professional traders too. In order to avoid this deception, you buy, hoping that the fall of price stops or the the rise goes on. Then, as in the image given by Keynes, the music stops and you cannot sit because all the seats are occupied.