Maladaptive Beliefs

"An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative. The distinction between investment and speculation in common stocks has always been a useful one and its disappearance is a cause for concern. In most periods the investor must recognize the existence of a speculative factor in his common stock holdings. It is his task to keep this component within minor limits, and to be prepared financially and psychologically for adverse results that may be of short or long duration.

There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.

– Benjamin Graham, The Intelligent Investor

Among the most persistent questions I hear is why we don’t just adapt to the reality that the Federal Reserve will never again “allow” the market to experience a serious decline. The problem with this view is that it rests on the premise that Federal Reserve policy supports the market in a clear-cut and mechanical way, when its effectiveness actually relies on the speculative psychology of investors.

We can certainly concede, and indeed must concede, that replacing a mountain of interest-bearing Treasury bonds with a mountain of zero-interest base money can both manipulate and disfigure investor psychology. It’s a simple fact that once a dollar of base money has been created, someone in the economy must hold it at every moment in time, in the form of base money, until that base money is retired. Provided investors are inclined to speculate (so that they rule out the potential for meaningful capital losses), the discomfort with zero-interest base money encourages each successive holder to chase riskier securities that they imagine will provide them with a positive and higher return.

Each time a buyer puts the base money “into” the stock market, a seller takes it right back “out” – just like a hot potato. The zero-return base money has simply changed hands. The thing that “holds the stock market up” isn’t zero-interest liquidity, at least not in any mechanical way. It’s a particularly warped form of speculative psychology that rules out the possibility of loss, regardless of how extreme valuations have become. We’ve never seen this much zero-interest base money before, but we certainly have seen the speculative psychology it relies on, and it has always ended in tears.