When our market participants are largely investors, focused on the economics of business, the underlying power of our corporations to earn a solid return on the capital invested by their owners is what drives the stock market, and volatility is low. But when our markets are driven, as they are today, largely by speculators, by expectations, and by hope, greed, and fear, the inevitably counterproductive swings in the emotions of market participants—from the ebullience of optimism to the blackness of pessimism—produce high volatility, and the resultant turbulence that we are now witnessing became almost inevitable.

Is this speculation by mutual fund managers and by other market participants healthy for investors? For our financial markets? For our society? Of course not. In the very long run, all of the returns earned by stocks are created not by speculation but by investment—the productive power of the capital invested in our business enterprises. History tells us, for example, that from 1900 through 2007 the calculated annual total return on stocks averaged 9.5 percent, composed entirely of investment return, roughly 4.5 percent from the average dividend yield and 5.0 percent from earnings growth. (Dare I remind you that this return reflects neither the croupier costs of investing discussed in the previous chapter nor the erosion of inflation?)

What I call the speculative return—the annualized impact of any increase or decrease in the price-earnings (P/E) ratio or P/E multiple—happened to be zero during this period, with investors paying a little over $15 for each dollar of earnings (P/E = 15) at the beginning of the period, and about the same at the end. Of course, changes in the P/E can take place over long periods; but only rarely does the long-term speculative return add more than 0.5 percent to annual investment return, or subtract more than 0.5 percent from it.

The message is clear: In the long run, stock returns have depended almost entirely on the reality of the relatively predictable investment returns earned by business. The totally unpredictable perceptions of market participants, reflected in momentary stock prices and in the changing multiples that drive speculative returns, essentially have counted for nothing. It is economics that controls long-term equity returns; the impact of emotions, so dominant in the short term, dissolves. Therefore, as I wrote in my Little Book of Common Sense Investing (John Wiley & Sons, 2007), "the stock market is a giant distraction from the business of investing."

The distinction between the real market and the expectations market was perhaps best expressed by Roger Martin, dean of the Rotman School of Business at the University of Toronto. In the real market of business, real companies spend real money and hire real people and invest in real capital equipment, to make real products and provide real services. If they compete with real skill, they earn real profits, out of which they pay real dividends. But to do so demands real strategy, real determination, and real capital expenditures, to say nothing of requiring real innovation and real foresight.

In the expectations market, by contrast, prices are set, not by the realities of business just described, but by the expectations of investors. Crucially, these expectations are set by numbers, numbers that are to an important extent the product of what our managements want them to be, too easily managed, manipulated, and defined in multiple ways. What is more, we not only allow but seemingly encourage chief executives, whose real job is to build real corporate value, to bet in the expectations market, where their stock options are priced and exercised. That practice should be explicitly illegal, just as it is illegal in most professional sports. Imagine, for example, what would happen if National Football League quarterbacks or National Basketball Association centers were allowed to bet on their own teams' pregame spreads. Yet CEOs do exactly that, which is one reason why stock-option compensation creates huge distortions in our financial system.

Which is the winner's game and which is the loser's game? Betting on real numbers and real returns, and buying and holding stocks for the long haul? (That is, investing.) Or betting on expected numbers and ginned-up returns, and in essence renting stocks rather than owning them? (That is, speculating.) If you understand how the odds in gambling diminish your chances of winning—whether in the lottery, in Las Vegas, at the racetrack, or on Wall Street—your decision as to whether to be a speculator or an investor isn't even a close one.

Despite the elementary mathematics that guarantee the superiority of investment over speculation, today we live in the most speculative age in history. When I first came into the financial field in 1951, the annual rate of turnover of stocks was running at about 25 percent.^[6] It would remain in that low range for the better part of two decades, then gradually rise to above 100 percent in 1998, approaching the record 143 percent turnover rate of the late 1920s. Yet by last year, stock turnover had shot up another two times over. Turnover soared to 215 percent, and to 284 percent if we add in the staggering amount of speculation in exchange-traded funds (ETFs).

Consider a stark example of one of the new financial instruments that typifies the dramatic upsurge in speculation. In 1955, when the total market capitalization of the S&P 500 index was $220 billion, neither futures nor options that would enable market participants to speculate on (or hedge against) the price of the index even existed. Then index futures and options were created—a marketing bonanza for the financial field. These new products made it easy not only to bet on the market, but to leverage your bets as well. By the beginning of 2008, the value of these derivatives of the S&P 500 index—these futures and options—totaled $29 trillion, more than double the $13 trillion market value of the S&P 500 index itself. That expectations market, then, would be at least double the value of the real market, even if the high turnover activity in the S&P 500 index stocks themselves were not dominated, as it is, by speculative trading.

A simple example demonstrates that speculation is a loser's game. Assume that one-half of the shares of each of the 500 S&P stocks are held by investors who don't trade at all, and the other half are held by speculators who trade solely with one another. By definition, the investors as a group will capture the gross return of the index; the speculators as a group will capture, because of their trading costs, only the (lower) net return. The obvious conclusion: investors win; speculators lose. There is no way around it. So the orgy of speculation we are witnessing today ill serves our market participants. It serves only Wall Street.

When the perception—interim stock prices—vastly departs from the reality—intrinsic corporate values—the gap can be reconciled only in favor of reality. It is simply impossible to raise reality to perception in any short time frame; the tough and demanding task of building corporate value in a competitive world is a long-term proposition. Still, whenever stock prices lose touch with corporate values and bubbles begin to form, too many market participants seem to anticipate that values will soon rise to justify prices, instead of the other way around.

That's what a speculative mind-set does to investors. It encourages them to ignore the inevitable even as they discount the probability of the improbable. And then along comes a trading day like October 19, 1987, and the eternal verities of the real market once again reassert themselves. On that single day, which came to be known as Black Monday, the Dow Jones Industrial Average dropped from 2,246 to 1,738, an astonishing one-day decline of 508 points or almost 25 percent. There had never been such a precipitous decline. Indeed, the drop was nearly twice the largest previous daily decline of 13 percent, which took place on October 24, 1929 (Black Thursday), a distant early warning that the Great Depression lay ahead.

From its earlier high until the stock market at last closed on that fateful Black Monday of 1987, some $1 trillion had been erased from the total value of U.S. stocks. The stunning decline seemed to shock nearly all market participants. But why? In the stock market anything can happen—and I would argue the point even more strongly today.

Changes in the nature and structure of our financial markets—and a radical shift in its participants—are making shocking and unexpected market aberrations ever more probable. The amazing market swings we have witnessed in the past few years tend to confirm that likelihood. In the 1950s and 1960s, the daily changes in the level of stock prices typically exceeded 2 percent only three or four times per year. But in the year ended July 30, 2008, we've witnessed 35 such moves—14 were up, and 21 were down. Based on past experience, the probability of that scenario was . . .zero.

So not only is speculation a loser's game; it's a game whose outcome can't be predicted with any kind of confidence. The laws of probability don't apply to our financial markets. For in the speculation-driven financial markets there is no reason whatsoever to expect that just because an event has never happened before, it can't happen in the future. Metaphorically speaking, the fact that the only swans we humans have ever observed are white doesn't mean that no black swans exist. For evidence, look no further than the Black Monday I just mentioned. Not only was its occurrence utterly unpredictable and beyond all historical experience, but its consequences were, too. Far from being an omen of dire days ahead, it proved to be a harbinger of the greatest bull market in recorded history. So one never knows.

Nassim Nicholas Taleb captures this idea with great insight in his book, The Black Swan: The Impact of the Highly Improbable (Random House, 2007).^[7] But Taleb only confirms what we already know: In the financial markets, the improbable is, in fact, highly probable (or, as Taleb also notes, the highly probable is utterly improbable). Yet far too many of us, amateurs and professionals alike, investors and advisers and managers, continue to look ahead with apparent confidence that the past is prologue in the financial markets, based on our assumptions that the probabilities established by history will endure. Please, please, please: Don't count on it.

Daily swings in market returns have nothing to do with the long-term accretion of investment values. In fact, while there have been numerous black swans in our short-term-oriented and speculative financial markets, there have been no black swans in the long-term investment returns generated by U.S. stocks. Why? Because businesses—as a group—employ capital effectively, reacting to and often anticipating changes in the productive economy of manufactured goods and consumer services. Yes, for better or for worse, we are faced with cyclical swings in our economy, periodic recessions, and even rare depressions. But American capitalism has demonstrated remarkable resilience, plugging along steadily even as times change, driving growth in earnings and paying dividends that have risen apace over time, in step with our growing economy.

Nonetheless, there has always existed the serious risk that speculation in our flighty financial economy (emotions) might spread its contamination to our overproductive business economy (enterprise). The great U.S. economist Hyman Minsky dedicated much of his career to his financial instability hypothesis—"stability leads to instability"—which he summed up profoundly:

Long before the creation of the recent wave of complex financial products, Minsky observed that the financial system is particularly prone to innovation. He noted the symbiotic relationship between finance and industrial development, in which "financial evolution plays a crucial role in the dynamic patterns of the economy." When money-manager capitalism became a reality during the 1980s and institutional investors became the largest repositories of savings in the country, they began to exert their influence on our financial markets and the conduct of our business enterprises.

The crisis in our financial system that first became painfully evident in mid-2007 was a stark warning of Minsky's prescience. Among the few market participants who seemed to see it coming was Jeremy Grantham, one of the nation's most thoughtful professional investors. He entitled his brilliant year-end 2007 essay "The Minsky Meltdown." With the collapse of the stocks of government-sponsored Fannie Mae and Freddie Mac and the U.S. Treasury formally assuming responsibility for their debt obligations barely six months later, there was little doubt that Grantham's prediction had come to pass. Only time will tell whether this Minsky meltdown will be merely cyclical or powerfully secular.

Yet the financial markets—as speculative as they are from time to time—provide the only liquid instruments that facilitate our ownership of business and enable us to invest our savings. So, what to do in an investment world fraught with speculation, rarity, extremeness, and retrospective predict ability? Peter L. Bernstein, respected investment strategist, economist, best-selling author, and the recipient of a remarkable string of professional awards, provided sound advice in 2001 in an essay titled "The 60/40 Solution" (60 percent stocks, 40 percent bonds), a strategy focused on emulating investment tortoises rather than speculative hares:

Yet just a few years later, Bernstein changed his mind. Let me try to sum up in a few paragraphs the gist of his formidably influential article in the March 1, 2003, edition of his Economics & Portfolio Strategy.

I salute Peter Bernstein for marching, red cape and all, into an arena filled with bulls—and bears—and I admire him immensely for trying to reconcile the irreconcilable. And indeed there is much merit in what he recommends, however difficult it may be to implement. But what he is really recommending, in my judgment, is speculation. And it is a loser's game.

Whether market timing is motivated by greed or fear or anything else, the inescapable fact is that, for investors as a group, there is no market timing. For better or worse, all of us investors together own the total market portfolio. When one investor borrows from Peter (no pun intended!) to pay Paul, another does the reverse, and the market portfolio neither knows nor cares. This transfer of holdings among the participants is speculation, pure and simple.

Individually, of course, any one of us has the opportunity to win by departing from the market portfolio. But on what rationale will we base our market timing? On our conviction about the prospective equity premium?^[9] Concern about the known risks that are already presumably reflected in the level of market prices? Concern about the unknown risks? (It is no mean task to divine the unknowable.) Yes, as Bernstein says, "opportunities and risks will appear and disappear in short order." I agree with that proposition. But human emotions and behavioral flaws militate against our capitalizing on them. Count me as one who simply doesn't believe that market timing works.

Don't forget that your incredible success in consistently making each move at the right time in the market is but my pathetic failure in making each move at the wrong time. One of us, metaphorically speaking, must be on the opposite side of each and every trade. A lifetime of experience in this business makes me profoundly skeptical of all forms of speculation, market timing included. I don't know anyone who can do it successfully, nor anyone who has done so in the past. Heck, I don't even know anyone who knows anyone who has timed the market with consistent, successful, replicable results.

It is difficult enough to make even one timing decision correctly. But you have to be right twice. For the act of, say, getting out of the market implies the act of getting in later, and at a more favorable level. But when, pray? You'll have to tell me. And if the odds of making the right decision are, because of costs, even less than 50–50, the odds of making two right decisions are even less than one out of four. And the odds of making, say, a dozen correct timing decisions—hardly excessive for a strategy that is based on market timing—seem doomed to failure. Over, say, 20 years, betting at those odds would give you just one chance out of 4,096 to win (even when we ignore the negative impact of the transaction costs entailed in the implementation of each of those decisions).

One chance out of 4,096? Are those good odds to bet on? Suffice it to say that Warren Buffett doesn't think so. In mid-2008 it was reported that he took the opposite side of a not totally-dissimilar wager. He laid on a $320,000 bet with Protégé Partners, a firm that manages funds of hedge funds, that over the 10 years ending in 2017, the returns from Vanguard's flagship 500 Index Fund would top the collective return from the five (inevitably) speculative, freewheeling, market-timing, trade-churning hedge funds selected by Protégé's supposed experts. I'm partial, of course, but that's a bet I might even be glad to place with my own money. (Whoever wins, by the way, the prize money from both sides—$1 million, including interest earned—will go to charity.)

Of course, our markets need speculators—financial entrepreneurs, traders, and short-term traders, risk takers restlessly searching to exploit anomalies and imperfections in the market for profitable advantage. Equally certain, our markets need investors—financial conservatives, long-term owners of stocks who hold in high esteem the traditional values of prudence, stability, safety, and soundness. But a balance needs to be struck, and in my judgment, today's powerful and debilitating turbulence is one of the prices we pay for allowing that balance to get out of hand.

Most of the themes in the preceding paragraph appear in the brilliant 2001 memoir, On Money and Markets, by economist and investor Henry Kaufman, one of the wisest of all the wise men in Wall Street's long history. Clearly, Dr. Kaufman shares my concerns, as he expresses his own fears about the corporatization of Wall Street, the globalization of finance, the limits on the power of policy makers, and the transformation of our markets. In his final chapter, he summarizes his concerns:

I couldn't agree more. Indeed it is our failure to deal earlier with these very issues that set the stage for today's financial crises. So every one of us must be concerned about the momentary triumph of short-term speculation in our financial markets, of which we have far too much, at the direct expense of long-term investment, of which we have not nearly enough. But it is up to today's market participants particularly, as well as academics and regulators, to work together to restore that balance and return financial conservatism to its rightful preeminence. Otherwise, to paraphrase the concern cited earlier in this chapter that was expressed by Lord Keynes all those years ago, "the hazards we face now that enterprise has become a mere bubble on a whirlpool of speculation means that the job of capitalism is being ill-done."

That is what has happened, and our society cannot afford to let it continue.