Lesson 1 of 7
The 1929 crash
Borrowed money and a speculative mania ended in the 1929 crash, and shaped the securities laws and the margin of safety that followed.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Borrowed money let buyers own far more stock than their own cash covered, so a price fall could erase the loan and the buyer's own money with it.
- The crash of late October 1929 took a handful of trading days. The three-year decline after it is what reshaped how a generation read a price.
- Congress answered with disclosure rules, and Graham and Dodd answered with a method: price a business from its own filed numbers, not from the crowd's mood.
The 1929 crash was not a single bad day. It was the end of a multi-year rise built partly on money buyers had borrowed, followed by a decline that ran for years and reset how investors judged a price for a generation after it.
From the crash to the method built to answer it
- 1928Buying on borrowed moneyA rising market makes a loan against stock look easy to carry, and buying with borrowed money is common practice.
- October 1929The crashPrices fall hard over a few weeks. Loans that looked safe when prices rose are called, forcing more stock onto a market that already has too many sellers.
- 1932The bottomThe decline runs for close to three more years before shares find a floor, the stretch that did the lasting damage to how the era's investors thought about a price.
- 1933Securities ActCongress requires a public company to disclose the numbers behind a security it sells, answering the information gap the crash exposed.
- 1934Two answers, one yearThe Securities Exchange Act creates the SEC to oversee the exchanges and gives the Federal Reserve the power to cap borrowing against stock; Graham and Dodd publish Security Analysis, a method for pricing a business from its filed numbers.
Borrowed money cuts both ways
A loan against stock multiplies a gain while prices rise, and it multiplies a loss the same way once they fall. The buyer's own cash sits behind the loan, so it is the first thing to go.
A crash is days. A bear market is years.
The crash days of late October 1929 are what people remember, but the decline that followed ran for the better part of three years. A few days of falling prices and a multi-year decline are different lessons: the first is about a market's mood, the second is about what a business is actually worth while the mood keeps changing.
What the law changed
Before 1933, a company selling stock to the public owed investors no federal standard of filed numbers. The Securities Act of 1933 made disclosure a legal requirement. The Securities Exchange Act of 1934 created the SEC to oversee the exchanges those securities trade on. Neither act tells a buyer what a business is worth. Both make the numbers a buyer needs to work that out a matter of public record.
What Graham took from it
Graham lived through the crash and the years after it. Chapter 3 of the revised Intelligent Investor sets the era inside a century of market history. His answer, in chapter 20, was the margin of safety: pay enough below your own estimate of value that an error in the estimate does not decide the outcome.
Check yourself
A margin account is 10 percent down. The stock falls 20 percent. What happens to the buyer's own money?
- It falls by 20 percent, matching the stock
- It is wiped out, and the buyer owes the lender more besides
- It is unaffected because the loan absorbs the fall
Show the answer
Answer: B.
A 10 percent down payment is a small cushion under a large loan. A 20 percent fall in the stock is twice that cushion, so it erases the buyer's money and leaves a debt on top of it.What did the Securities Act of 1933 require of a company selling stock to the public?
- A guarantee that the stock could not lose value
- Disclosure of the numbers behind the security
- A ban on buying stock with borrowed money
Show the answer
Answer: B.
The Act made filed disclosure a legal requirement. It says nothing about whether a security is a good buy, only that the numbers behind it must be public.What is the difference between the crash of late October 1929 and the years that followed it?
- There is no difference; the crash days were the whole event
- The crash days were a headline; the multi-year decline is what reshaped how investors priced a business
- The years that followed were a smaller, less important event
Show the answer
Answer: B.
A few days of falling prices tests a market's mood. The years that followed tested whether a price paid for a business could be justified by what the business actually earned, which is the harder and more lasting question.Sources
- Galbraith, The Great Crash, 1929, 1955.
- Graham, The Intelligent Investor, revised edition 1973, chapter 3: a century of stock-market history.
- Graham, The Intelligent Investor, revised edition 1973, chapter 20, on the margin of safety.
- Securities Act of 1933 and Securities Exchange Act of 1934.
- Fisher, Common Stocks and Uncommon Profits and Other Writings, on the "new era" belief and margin buying ahead of 1929.
What this leaves out
- No index figures for 1929-32: the dated table starts in 1965.
- The margin account and its figures are a round, invented illustration of the mechanism, not a record of any real account.
- Nothing here is advice about borrowing to buy any security.