Apologies to those of you who may already have read this in my book, but I hereby give myself permission to reprint this excerpt. If only I had had the brains to read it before I shorted stocks that – had I bought them instead – would have landed me on the Forbes 400,000.
Anyway, here’s the excerpt:
David Dreman, author of The New Contrarian Investment Strategy, writing in Barron’s, made a good case against random walk [the idea that stock prices always reflect all available information about a stock, and that, thus, their future moves can’t be predicted]. He pointed out that stock markets have always been irrational and concluded that a rational man could therefore outdo the herd. “Market history gives cold comfort to the Random Walkers,” he writes. “‘Rational’ investors in France, back in 1719, valued the Mississippi Company at 80 times all the gold and silver in the country – and, just a few months later, at only a pittance.”
It is true, I think, that by keeping one’s head and sticking to value, one may do better than average. But it’s not easy. Because the real question is not whether the market is rational but whether by being rational we can beat it. Had Dreman been alive in 1719, he might very reasonably have concluded that the Mississippi Company was absurdly overpriced at, say, three times all the gold and silver in France. And he might have shorted some. At six times all the gold and silver in France he might have shorted more. At twenty times all the gold and silver in France he might have been ever so rational – and thoroughly ruined. It would have been cold comfort to hear through the bars of debtors’ prison that, some months later, rationality had at last prevailed. A driveling imbecile, on the other hand, caught up in the crowd’s madness, might have ridden the stock from three times to eighty times all the gold and silver in France and, quite irrationally, struck it rich.
I am not calling you a driveling imbecile. And I am not saying the Internet is a scam – it is the future – even though, by coincidence, it may indeed be valued at 80 times all the gold and silver in France. (Gold and silver were more important in France, and France more important in the world economy, in 1719 than they are today.)
The point is simply that just because I foolishly short stocks from time to time doesn’t mean that you should make the same mistake. It’s far, far safer to buy puts. The problem is, puts on crazily valued stocks are, understandably, crazily expensive – and I am too cheap to pay the premium. So I often go short rather than buy puts, and, nearly as often, twist myself into knots of self-loathing as I watch the nightmare unfold.