Don't Make These 3 Investment Mistakes - Lessons from The Great Crash of 1929

I recently finished reading The Great Crash 1929 written by John Kenneth Galbraith who is famous for his work documenting the booms and busts of financial markets throughout history.  I've done a fair bit of reading on other market crashes, but felt it was time to dive a little deeper into what is considered one of the worst in history. Let's start by setting the backdrop with what was occurring at the time.

Relative to the past, the 20s in America was a pretty good time to be in business.  America had won the war and the country was in much better economic shape than their European allies. Business was booming, wages were growing, and prices remained stable.  Poverty was still very prevalent, but more people were beginning to join the middle class.

The rich were doing very well and to those watching, the potential to get rich seemed well within any American's grasp. Capitalism and the American Dream were thriving. The stock market in particular, made it seem as if it were every American's birth right to be rich.  Most didn't stop to question whether this rate of growth could actually last forever? Why would they?  They were making more money than they ever had before.

Stocks prices initially began rising back in 1924, with a few setbacks along the way.  By 1928, speculation had arrived in Wall Street and according to Galbraith stocks, 'had taken a leave from reality.'  Prices of stocks were rising, causing more people to want in, leading to even further increases.  Investors were flocking, and with each new wave, prices jumped even higher, reaffirming the naive belief that this could continue indefinitely. High levels of speculation create a self-fulfilling bubble where each price increase re-affirms peoples original decision.

Individuals end up investing more and those watching from the side lines become attracted to what seem to be easy profits. This process can repeat itself several times over, generating more momentum each time, and distorting prices to levels that are outright lunacy. With everyone and their dog talking about stocks, one could ask the question (though few did) how could prices go any higher? Enter leverage.

Leverage allowed individuals to purchase even more stock than they already owned causing prices to go up even further.  As everyone was busy making money, most investors never stopped to question leverage and how it works. At the time, individuals could purchase stock on 10% margin.  This meant that you borrowed 90% from a bank or financial institution.  You only had to put up 10% of the money! The stocks purchased were used as collateral for the loan (the view at the time was that stocks only went up, so they were perfectly good collateral.)

Using another person's money also meant increased returns. Higher returns meant more people wanting in, leading to further increases in stock prices.  What everyone failed to recognize was the way in which leverage would work in reverse. Ultimately, the bull run of the market ended on October 29th, 1929. Following this was a period of significant pain with the Great Depression, which lasted for ten years. Many lost all their savings, and their job along with it.  

Although the depression has less of an agreed upon cause, there is a common consensus behind the Great Crash of 1929. Most experts point to things like herd mentality, mass speculation, and the overuse of leverage.  I think it's important we examine each of these, as each is still seen in investors' behaviours today.

Herd Behaviour

People have the tendency to mimic the actions of a larger group, whether rational or irrational.  With herd mentality, people make decisions that they likely would not have made without the influence from the crowd.  In 1929, you couldn't not hear about all the money being made in the stock market. The fear of missing out drove many to enter the markets and drive prices to levels that were exorbitantly high.

As we've learned from all market crashes, herd mentality works in the opposite direction just the same.  When prices begin to drop, the bandwagon gets real light, real quick.  No one wants to be the last one holding the bag.  The ironic part of it all is that being successful in investing requires you to be different from the crowd.

Speculation

Speculation can be summed up as buying an investment in the hopes that you can sell it to someone else at higher price, later in time.  This is different than buying a business that produces profits and cash flow, that you intend to own for a long period of time (this is what I would call an investment).  Although many have made money speculating, it is extremely hard to do consistently. Buying based upon a gut instinct, analyst reports, economic indicators, or because you think the product is really great, are all forms of speculation.  

Successful investors ask so many more questions like; how much cash does the business generate and how much can it put back in my pocket?  What type of competitive advantage does the business have? How well does the business re-invest their profits? What is the management teams track record?  Unless you're going through quarterly and annual reports, and listening to management calls, chances are you are speculating.

"Choosing individual stocks without any idea of what you're looking for is like running through a dynamite factory with a burning match. You may live, but you're still an idiot." - Joel Greenblatt

Leverage

Borrowing money to invest can be very alluring because it results in much higher returns when the investment works out.  With that said, during a market crash, investors find out exactly how leverage works in reverse.  Just as leverage magnifies gains, it does the exact same for losses. Leverage combined with speculation and herd mentality, opens you up to some very scary mistakes as seen in the case of 1929 and so many other market crashes.  Leverage should very much be left to the pros, and even then, there are many who should avoid it like the plague.

In closing, 1929 was not the first market bubble that burst, and it was not the last. Markets never go up in a straight line, corrections and recessions are par for the course.  Avoiding some of the mistakes made by the investors during 1929 will help mitigate some of the pain that comes with corrections and allow you to make smart and rational decisions with your money.  If you're prone to any of the above mistakes it may be in your best interest to work with a professional who you trust, and has your best interests in mind.

- Brandt Butt, Investment Advisor

Brandt Butt is an Investment Advisor at award winning firm Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Brandt Butt who is a Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.