The Madness of Markets: Alex Edmans on Why Smart Investors Make Crazy Decisions

“When people trade, even before fees and commissions, the average trade loses money.” — Alex Edmans

 

Isaac Newton might be able to foresee the movement of the stars, but he couldn’t foretell the madness of men. It was a lesson that cost the great physicist £4 million (in today’s money) when he threw his fortune into the South Sea Bubble. This priceless parable in Newtonian psychology opens The Madness of Markets, the new book by Alex Edmans — London Business School finance prof, old friend of the show, and author of the bestselling May Contain Lies.

 

Dr Edmans’s prognosis is bracingly unflattering to guys like Isaac Newton and Mark Twain who splurge their fortunes on speculative ventures. Intelligence, he reminds us, is domain-specific, but many smart people simply aren’t intelligent enough to realize this. So, in the age of Robinhood — when we can all trade anything from stocks, options, crypto to NFTs — the supposed wisdom of crowds is sometimes driven over the cliff by the irrational exuberance of dumb individuals.

 

Speaking of driving off the cliff, ninety percent of us think we’re above-average drivers, Edmans jokes, and this same delusion applies to markets. Unfortunately, such stupidity can be expensive for big brain types like Newton or Twain. “When people trade, even before fees and commissions, the average trade loses money,” he warns.

 

So close your Robinhood account and stick your cash in the bank? No, not quite. Know your edge, Edmans reminds us. And when it comes to making sense of the current AI boom, Edmans offers some particularly wise words. The AI sector trades at 25 to 30 times earnings rather than Cisco’s bubble-era 190, he notes, so it’s unlikely anyone will lose their life’s savings on Anthropic or OpenAI.

 

That said, the good doctor Edmans advises, don’t confuse your self-worth with your net worth. That’s a rookie conceit that only somebody as smart as Isaac Newton would fall for.

 

Five Takeaways

 

•       Newton’s £4 Million. The book leads with the smartest victim on record: Isaac Newton rode the South Sea Bubble, banked a tidy profit, dove back in at the very top, and lost £20,000 — £4 million today — lamenting that he could predict the movement of the stars but not the madness of men. (Andrew’s companion case, via last month’s Citizen Twain episode with Jeff Jarvis: Mark Twain, genius writer, ruinous investor.) The lesson is that smartness is domain-specific: beating the market requires knowing the company, the industry, and — crucially — what’s already priced in. A great secretary of state evaluating Theranos is the Dunning-Kruger effect in a suit: expertise misapplied, one piece of the mosaic mistaken for the whole. Even Warren Buffett’s edge, Edmans notes, is partly restraint — don’t watch the market too closely, or you’ll mistake noise for signal.

•       Know Your Edge. Edmans’s framework: play the market only if you can name your edge — knowledge (unique insight into a sector) or endurance (capital that can’t be withdrawn by flighty clients). His endurance exemplar is Clare College, Cambridge, which borrowed £10 million in the depths of 2008 and put it all into equities via its “2048 Fund”: a decade later the portfolio had tripled while the loan had merely doubled. No edge? Then “be humble” and hold a low-cost, globally diversified index fund — because the alternative is expensive. In the age of Robinhood, the market for everything has been democratized; the zero-commission promise is a myth (retail options bid-ask spreads run 20 to 25 percent); and the brokerage data is brutal: the average retail trade loses money before fees. “I’m generally a libertarian,” Edmans concedes