This is the best chapter in the book and one of the most important economics essays of all time. Read it here.
Upon rereading it, I am overwhelmed by its insight and also its relevance to our current predicament. I object to the final paragraph on the nationalization of investment but still this is a stellar performance.
It is section IV which did the most for me and I put that under the fold for your consideration...
In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The
essence of this convention — though it does not, of course, work out
quite so simply — lies in assuming that the existing state of affairs
will continue indefinitely, except in so far as we have specific
reasons to expect a change. This does not mean that we really believe
that the existing state of affairs will continue indefinitely. We know
from extensive experience that this is most unlikely. The actual
results of an investment over a long term of years very seldom agree
with the initial expectation. Nor can we rationalise our behaviour by
arguing that to a man in a state of ignorance errors in either
direction are equally probable, so that there remains a mean actuarial
expectation based on equi-probabilities. For it can easily be shown
that the assumption of arithmetically equal probabilities based on a
state of ignorance leads to absurdities. We are assuming, in effect,
that the existing market valuation, however arrived at, is uniquely correct in
relation to our existing knowledge of the facts which will influence
the yield of the investment, and that it will only change in proportion
to changes in this knowledge; though, philosophically speaking it
cannot be uniquely correct, since our existing knowledge does not
provide a sufficient basis for a calculated mathematical expectation.
In point of fact, all sorts of considerations enter into the market
valuation which are in no way relevant to the prospective yield.
Nevertheless the above conventional method of calculation will be
compatible with a considerable measure of continuity and stability in
our affairs, so long as we can rely on the maintenance of the convention.
For if there exist organised investment markets and if we can rely
on the maintenance of the convention, an investor can legitimately
encourage himself with the idea that the only risk he runs is that of a
genuine change in the news over the near future, as to the
likelihood of which he can attempt to form his own judgment, and which
is unlikely to be very large. For, assuming that the convention holds
good, it is only these changes which can affect the value of his
investment, and he need not lose his sleep merely because he has not
any notion what his investment will be worth ten years hence. Thus
investment becomes reasonably “safe” for the individual investor over
short periods, and hence over a succession of short periods however
many, if he can fairly rely on there being no breakdown in the
convention and on his therefore having an opportunity to revise his
judgment and change his investment, before there has been time for much
to happen. Investments which are “fixed” for the community are thus
made “liquid” for the individual.
It has been, I am sure, on the basis of some such procedure as this
that our leading investment markets have been developed. But it is not
surprising that a convention, in an absolute view of things so
arbitrary, should have its weak points. It is its precariousness which
creates no small part of our contemporary problem of securing
The insights here have yet to be fully mined.