Book Extract: The New Financial World

The seminar room was classic harvard: paneled walls; a coffered ceiling; and a long, beautiful table. Professors and graduate students wandered into the room to take their seats following the accustomed pecking order that reserves prime spots for senior professors and chairs along the wall for doctoral students. Into the room strode a young historian who seated herself at the head of the table. She unfolded a sheaf of papers, waited for the room to still itself, and then took a hand grenade out of her satchel. Without a word she set it upright in front of her. It was not clear to the audience whether they should smile or simply bolt.

Regardless, Julia Ott succeeded in getting their attention. Her seminar that day at Harvard Business School was a lesson in how Americans adopted stock market investing. The hand grenade was from the First World War. It was a reminder that much of American attitudes toward investing emerged in the wake of the Great War.

As post-war Russia in the 1920s marched toward a Marxist state, Americans moved vigorously in the opposite direction with a distinctive American kind of idealism and fervor. The subject of Julia Ott’s lecture—and the subject of her extensive dissertation—was the profound shift in the American mind about the issue of stock market investing. While Europeans, particularly the British, had long relied on capital markets as a means of savings and investment, investing by American households increased significantly only during the First World War. The US government issued savings bonds to finance the American war effort, and these were purchased, in part, as a matter of patriotic duty. As the US government retired this debt, investors sought financial substitutes, and brokers sought additional product.

Julia Ott is now a historian at the New School of Social Research in New York and an expert on the conversion of America to the cult of equity in the early twentieth century—in her words, a “shareholder democracy.” Retail investing was pushed, not pulled, particularly at the outset. While Russians were being trained in the 1920s to reject the bourgeois idea of money and savings, Americans were introduced to a sophisticated new world of capital markets by brokers and bankers who saw retail investing as a new profitable area of marketing. The zeitgeist of market speculation had finally crossed the Atlantic.

...Julia Ott points out that investment in American companies in the 1920s became a means for self-improvement, self-reliance, and personal empowerment. For the price of a share, an investor became a voting partner in a giant company and a stakeholder in its future. These themes did not emerge spontaneously in American society; rather, they were carefully nurtured by Wall Street—particularly through the promotional activities of the New York Stock Exchange. Julia Ott’s research in the archives of the exchange turned up a vast amount of material about how the idea of a shareholder democracy was managed—not only through speeches and publicity releases, but also through such populist media as financial cartoons that distilled the complexities of financial operations for ordinary people and appealed to aspirations of family security and self-improvement.

In contrast to the popular pre-war notion of a Wall Street dominated by insiders like Daniel Drew, Cornelius Vanderbilt, and J. P. Morgan, the New York Stock Exchange in the 1920s emphasized fairness. In the “New Era” of stock market investing , the small American investor was no longer a victim of market manipulation by insiders—the New York Stock Exchange promoted itself as the seal of approval for a square investment deal. If common stocks once were synonymous with speculation and back-room trickery, they were now transformed, via a period of patriotic fervor and sudden familiarity with brokers and investment portfolios, into a major new “appliance” in the American household...

Stocks Versus Bonds: Keynes was right. Stocks captivated the American imagination in the 1920s in a fundamentally different manner from the British investor movement of the Victorian era. Most of Henry Lowenfeld’s studies of global diversification in London used bonds to illustrate a sound investment policy. The Foreign and Colonial Government Trust was fashioned to capture high average bond yields, not capital appreciation of shares. Keynes was an exceptional early advocate of equities as the future of finance, but he was a bit ahead of his time in Britain. But in America, tastes turned sharply toward equities. Americans still bought bonds, but people grew increasingly wary of them. One thing made bonds less safe in the modern era: they carried the risk of inflation.

The hyperinflation in Germany after the First World War horrified the world. From 1921 to 1924, prices in Germany rose more than a trillion times over: currency reform in 1924 involved lopping off twelve zeros from the bills in circulation. Money was literally not worth the paper it was printed on...

Yale economist Irving Fisher went so far as to postulate that ordinary people could not even perceive the terrible effects of currency devaluation. In a curious, perhaps unconscious echo of Marxist “money fetishism,” Fisher coined the phrase “money illusion” to describe the human tendency to believe that the “nominal” value of currency was somehow fixed and reliable. He argued instead that people needed to be convinced to use “real” value: the value

after accounting for inflation. In Fisher’s view, people got hung up on the monetary prices as reference points for the value of goods and ignored the extent to which this was determined by the quantity of money in circulation. His prescription to savers: stay away from money and bonds. Future dollars might be worthless. Better buy real things—like real companies. Shares in American corporations promised not only a dividend cash flow but also a stake in tangible corporate assets whose monetary value would automatically rise when the government printed money...

Fisher’s contribution to financial economics was particularly important. He took the mathematics of present value (first formalized by Fibonacci!) and applied it to investment decisions. In Fisher’s analysis, corporate managers acting in the best interests of shareholders should choose projects with the highest positive net present value that takes into account not only the time value of money but also the risk of the project. Generations of Yale graduates who took his courses in finance learned to apply this rational decision criterion. Fisher’s net present value equation is the workhorse of all modern financial analysis today. Fisher’s study of corporations and his analysis of the effects of inflation led him to strongly advocate stock investing as opposed to bond investing. It was advice he took himself, moving much of his personal wealth—and the savings of his well-to-do wife and her family—into equities.

Fund A and Fund B: Edgar Lawrence Smith worked on Wall Street as a bond analyst in the early 1920s. Interested in the stock market craze, he ran a test to see whether an investor who held stocks would have done better than an investor who held bonds over the long term. This was a quite different study than Henry Lowenfeld’s of decades earlier. He was not interested in global investing or in risk per se but rather in return. Which did better—stocks or bonds?

Smith’s experiment was simple. He checked whether the actual cash flows from investing from the 1830s to the 1920s in corporate stocks would have covered the payouts to bondholders. He found that over the long term, stocks practically always beat bonds. He also argued that equities should be able to make a steady dividend payout that grew proportionally as a percentage of market values. He published the study Common Stocks as Long Term Investments in December 1924. ...Smith turned the traditional idea of safe investing on its head: bonds, which were once considered conservative and safe, were now deemed extremely risky.

...In Smith’s careful empirical analysis, replete with graphs and figures, American investors found a convincing argument for revolutionizing the way they saved for the future. Benjamin Graham and David Dodd, fundamental value investors of the 1930s, scoffed that Common Stocks as Long Term Investments was “destined to become the official ‘textbook’ of the new-era stock market.” John Maynard Keynes reviewed it positively in 1925. Irving Fisher was even more enthusiastic, arguing that Smith had started a trend that fundamentally altered the relative demand for stocks and bonds.

Edgar Smith launched the Investors Management Company shortly before the publication of his landmark study. It offered its services on a strictly fee basis—eliminating some of the extreme conflicts of interest held by other firms. Unlike big Wall Street companies, Investors Management Company did not underwrite securities and then park the failures in their investment trusts.

The firm offered two products: Fund A and Fund B. Both allowed investors to hold a diversified portfolio of common stock, formed chiefly according to the principles outlined in his book. Fund A planned to pay out 5% per year in dividends, which was the rate Smith figured was a sustainable yield based on historical analysis. Fund B allowed investors to plow back all dividends by reinvesting in more common stock shares. Smith not only demonstrated that stocks were a superior long-term investment; by launching his investment funds, he also offered Americans a vehicle to capitalize on his research. Although the Investors Management Company Funds A and B were not the very first mutual funds in America, they were very prominent and immediately attracted imitators.

Just as suddenly as Americans became infatuated with buying stocks, they fell in love with investment trusts. The simple idea of pooling investor money and buying a diversified portfolio of securities is a great one and is certainly not new. After all, the Dutch invented mutual funds every bit as sophisticated. The British model for American funds—including the famous Foreign and Colonial Government Trust—was widely acknowledged in the 1920s. Trusts were even referred to as a “British” style of investing. The American wrinkle was the emphasis on equity. Irving Fisher was also a big fan of investment trusts: the risks that… attach to [common stock] may be reduced, or insured against, by diversification . . . investment trusts and investment council tend to diminish the risk to the common stock investor. This new movement has created a new demand for such stocks and raised their prices, at the same time it has tended to decrease the demand for, and to lower the price of, bonds.

Notice what this statement predicted. Fisher reasoned that, as small investors began to use diversified investment trusts as vehicles to hold stocks, the risk of their portfolios would go down. Historically, the risk of holding just one stock is about twice the risk of holding a portfolio of stocks. If you can buy a portfolio as easily as a single share in one company, then you can double your stock market investment while keeping the same level of risk. Fisher predicted that, because of this diversification effect, small investors would dump bonds and buy stocks. This would push stock prices up, and the market would reach a “permanently high plateau.” In the optimistic world of the 1920s, Fisher foresaw a new financial order based on stocks and investment trusts. Investors big and small would hold investment trusts that offered broad, diversified stock market portfolios. They would provide a sustained demand for shares in America’s corporations.

Unfortunately, Fisher made his prediction in the summer of 1929, and the American public never forgot it. Not only did Irving Fisher lose his own life savings, but he lost his in-laws’ savings as well—and he was devastated to have encouraged a nation of small investors to invest with him in the market.

Yale University bailed him out by buying his grand house on Prospect Street in New Haven and renting it back to him until he passed away in 1947. The cloud of his market forecast followed him to the grave.

Excerpted with permission from Money Changes Everything: How Finance Made Civilization Possible, by William N. Goetzmann. Copyright Princeton University Press 2016.