Friday, August 14, 2020

The Dutch East India Company and The Dividend Discount Model (plus behavioral finance, first bear raid, first dividend, first equity derivatives etc.)

Checking in at FT Alphaville for the comments on their James Montier piece, the conversation appears to have descended, like a cocktail party an hour after it was time to go, into one group calling for a spellcheck on 'stonks' (same people I'm guessing who don't call for the check) and another group over by the hearth, earnestly discussing the dividend discount model of equity valuation.

All of which is just my way of hooking ever-so-patient reader into reading a bit about the Granddaddy of all exchange traded investments, the VOC=Vereenigde Oost-Indische Compagnie "United East India Company":

Behavioral Finance at The World's First Stock Exchange
We've looked at the market for the Dutch East India stock a few times.
2017's "Mokyr: 'How Europe became so rich":
Because Dutch is the language of love?
Then I give up. How did Europe become so rich?
From Aeon:...
Here's the introduction to 2012's "The World's First Stock Exchange (and first bear raid, first dividend, first equity derivatives...)'":
‘This little game could bring in more money than contracting charter parties for ships bound for England’, wrote Rodrigo Dias Henriques to Manuel Levy Duarte on 1 November 1691.1 Dias Henriques was referring to the ‘game’ of trading shares of the Dutch East India Company (Verenigde Oost-Indische Compagnie, VOC, founded 1602) and its derivatives* on the Amsterdam securities market.
A marvelous piece of scholarship from the University of Amsterdam.
VOC=Vereenigde Oost-Indische Compagnie "United East India Company" was created two years after the British East India Company.

How the Amsterdam market for Dutch East India Company
shares became a modern securities market, 1602-1700

Also from that post, the first dividends were not paid for seven years but once they started...
...Shareholders could collect their first dividend in April 1610: 75% of the nominal value of their share in mace.39 In November of that same year, another 50% in pepper was distributed, together with 7.5% in cash – the latter distribution was only for those shareholders who had also collected the pepper. In March 1612, a distribution of 30% in nutmeg followed.40 Shareholders who had collected all dividends in kind had received a total of 162.5% of the nominal value of their shares, but the market value of the spices proved to be significantly lower. Shareholders complained that the distributed dividends had a market value of only 125%41; the sudden abundance of spices on the market had brought the prices down....
These guys were not believers in the Modigliani-Miller Dividend Irrelevance Theorem...
[or the DDM]

In 2016's "Frontrun the Bank of England for Fun and Profit" former FT Alphavillein David Keohane [now FT Paris] jogged my memory with his "Confusion and the BoE’s corporate bond buying scheme":
...Re: Mr. Keohane's headline, I couldn't help thinking of De la Vega's 1688 book Confusion of Confusions regarding the trading of Dutch East India Company stock.
The analysis in The Confusion of Confusions :  Between Speculation and Eschatology is a good introduction.

As another review puts it:
...He shows us all the tricks of the trade such as front-running large orders and spoofing the market with fake news to achieve a more favorable trading price.
Which leads us to today's headline story from Taylor & Francis Online (style note: by using the abbreviation CC rather than Confusion de Confusiones the writers save thousands of letters):

Behavioral Finance in Joseph de la Vega's Confusion de Confusiones
In this paper, we link Joseph de la Vega's work Confusion de Confusiones, written in 1688, with current behavioral finance and propose that Vega be considered the first precursor of modern behavioral finance. In addition to describing excessive trading, overreaction and underreaction, and the disposition effect, Vega vividly portrays how investors behaved 300 years ago and includes interesting documentation on investor biases, such as herding, overconfidence, and regret aversion.

Research on behavioral finance has seen explosive growth in the last 30 years. However, we can trace evidence of behavioral finance in writings before this period. In this paper, we claim that the work Confusion de Confusiones (hereafter CC), written by Joseph de la Vega in 1688, is the first study we have a record of that documents investor biases and thus is a clear precursor of the current behavioral finance literature.

Joseph de la Vega's work has been widely studied from different points of view. He wrote about diverse subjects, primarily philosophy and poetry. His active commercial life began in Amsterdam in 1683. CC was a consequence of his financial experience. This is the first and oldest book about the stock exchange and even today is a good description of financial transactions.

As with every first book of its class, some authors (Neal [1983] Neal, L.Efficient Markets in the Eighteenth Century. The Amsterdam and London Stock Exchanges.” In J. Atack (ed.), Proceedings of the Business History Conference, Urbana, IL, 1983. [Google Scholar]) have conferred on it great importance in the constitution and operations of other markets, such as the London Stock Exchange. This work has been studied not only by economists (Perramon [2011] Perramon, J. M. Influència de la Informació Económica en la Borsa a Confusión de Confusiones. Barcelona: Universitat Autònoma de Barcelona, 2011. [Google Scholar], Leinweber and Mandhavan [2001]) but also by historians (Gelderblom and Jonjer [2005], Petram [2011] Petram, L. O.The World First Stock Exchange: How the Amsterdam Market for Dutch East India Company Shares Became a Modern Securities Market, 1602-1700.” University of Amsterdam: Faculty of Humanities, 2011. [Google Scholar]). A sign of the importance of this book is that the European Federation of Stock Exchanges (FESE) offers an annual prize in the name of José de la Vega to the best study on financial markets.

This book is not a work on stock exchanges or economics, nor is it a legal analysis. It acts more as a description of the beginning of the activities and games of the stock exchange. Nobody by that time had tried to understand and describe this activity. Even in Amsterdam, there was no technical work about this frantic activity.

The style of Vega's book is very rhetorical and makes frequent references to Latin and Greek mythology, rendering it difficult for modern readers to approach. Vega is aware of this difficulty but prefers to be understood by only a few readers.

There will be readers capable of understanding all of what I say. Perhaps there will not be many but there will be some and this is what I want. (para. 142)
It is evident from the reading of this book that stock exchange activity is something subject to all sorts of uncertainty. The prices of the two companies then traded in Amsterdam varied wildly due to natural phenomena or to the irrational activity of the traders. In turn, news that was true, false, and invented complicated the formation of prices. Joseph de la Vega detects and colorfully documents some investor behaviors that currently are frequent topics in the behavioral finance field. In addition, he offers several pieces of advice that anticipate the current state of behavioral finance.
Other precursor studies of behavioral finance have been identified, such as the 1896 work by Gustave le Bon, The Crowd: A study of the Popular Mind, an influential book on social psychology, and Selden's [1912] Psychology of the Stock Market: Human Impulses lead to Speculative Disaster, but all of these studies were written later than CC.

Using the taxonomy of applications of behavioral finance described by Barberis and Thaler [2005] Barberis, N. and R. Thaler. “A Survey of Behavioral Finance.” In R. Thaler (ed.), Advances in Behavioral Finance vol.II. New York: Russell Sage Foundation and Princeton University Press, 2005, pp. 175. [Google Scholar]—the cross-section of average returns, closed-end funds and comovement, investor behavior, and corporate finance—the work of Joseph de la Vega can be framed in the area of documenting investor behavior. In addition, within this broad field of studies on investor behavior, CC focuses only on some of the main biases.

Vega's book, CC, written in Spanish, was translated into Dutch in 1939, and some scripts were translated into English in 1957. In this paper, we will use, where possible, the 1957 English translation, but on several occasions we offer the reader the present authors’ translation, as the English translation is not complete. Author's translations are indicated at the end of quotations. The Spanish version used in this paper is the one edited jointly with the Dutch translation in 1939, as it has numbered paragraphs, which facilitates quotation. The paragraph number is specified in brackets.
The paper is organized as follows. In the second section we introduce Joseph de la Vega and his work. In the third section we document the behavioral biases found in CC, and we comment on them. We conclude in the fourth section. At the end of the paper, we include an Appendix, where the original Spanish quotes cited along this paper can be found.

Joseph de la Vega is the author of Confusion de Confusiones, but the first confusion concerns his own name and birthplace.

His name varies between his works for two reasons. In Spain at that time, a change of place or kingdom of residence often led to this variation, but also Jews frequently changed their names when they converted to Christianity or emigrated (Torrente [1980]).

His family was from Cordoba, but it is not clear whether he was born in 1650 in Cordoba or in Amsterdam because his parents had immigrated to Amsterdam by that time.

CC, published in Amsterdam in 1688, does not pretend to be a treatise on the stock exchange; rather, it is “a set of the experiences of a gambler” (Anes [1986] Anes, G. Introducción: en Confusión de Confusiones. Ámsterdam, 1688. Madrid: Bolsa de Madrid, 1986. [Google Scholar]) that contains references to complex exchange operations, philosophical elements based on classical culture, and a complete description of how the Amsterdam Stock Exchange operated. Joseph de la Vega lived in the collapse of the Oriental Indies Company of the Netherlands, which financially ruined him....MUCH MORE
If interested, the extracts of Confusion de Confusiones at the Hathi Trust is probably the most accessible version online. If your Spanish is up to it the the version at the Digital Library for Dutch Literature is the most complete. (508 page PDF)
And again, the analysis in The Confusion of Confusions :  Between Speculation and Eschatology is a good introduction.