One of the greatest financial crises in the United States, the stock market crash of 1929, is unique because of the complexity of the crisis. There was not one root cause, but rather a handful of mistakes, fraud, speculation, and more that led to the market’s demise. One of the practices that caused the crash was investment pooling. Investment pools worked in the early 1900s before they became regulated and the effect they had on the stock market as a whole. This blog is a part of a series written by our summer intern, Makenna. This series is based off excerpts from the well-known book, A Random Walk Down Wall Street.
A group of investors that pool their money to invest in assets is called an investment pool or investment club. The benefit of this strategy is that you can use it to diversify risk by spreading out a large amount of money across different assets and distributing returns, similar to mutual funds. Before they became regulated in the 1930s, some investment pools used fraud as a method to increase profit. First, the pool manager would slowly begin purchasing shares of a stock in hopes of accumulating a large amount of stock without being too obvious. Then, the manager would conspire with the stock’s exchange specialist, who held information about buy and sell orders from other investors, to gauge how much to manipulate the stock. Even stock market commentators were part of the scheme by reporting on how well the manipulated stock was performing to increase consumer confidence. Next, the pool manager directed the pool investors to trade with each other in order to drive up the stock price. Finally, once the public began investing heavily in what seemed to be a prosperous stock, the investment pool would quietly sell their shares for profit before the public could realize they had invested in a worthless stock. This fraud devastated countless investors, and investment pools soon became regulated to protect against fraud and asymmetric information in the market.
Investment pools manipulated the stock market to such a high degree that they played a significant part in the stock market crash. Perhaps the most prominent example of investment pools manipulating stocks was in 1929 when RCA stock rose 61 points in only four days, just to plummet soon after and devastate investors. Speculation became an extremely popular activity, but in the end, only the investment pools and other market manipulators seemed to profit from the craze. Innocent people entrusted their money to these schemes and lost confidence in the market when they were cheated. Often, speculators would invest using borrowed money from banks. When stocks plummeted from investment pool manipulation, these speculators lost their money and were unable to pay back loans to banks. This huge loss in funds to the bank also meant that people who kept their savings in those banks lost their money as well. Fraudulent behavior in the stock market not only affected investors, but it affected anyone who deposited money in a bank that lent to investors.
While investment pools and other dishonest behaviors are less popular now due to regulations such as the Securities Act of 1933 and the Securities Exchange Act of 1934, their destruction of the market in the late 1920s teaches an important lesson: speculation is almost never profitable. It is wise to invest your money in assets that you understand so that you avoid unexpected crashes. In addition, you should not invest with borrowed money because there is a real possibility that you will not be able to pay it back if the asset decreases in value. The last thing you want is to end up with enormous debt on top of losing money in the market. Know your risk level and protect the wealth you have worked hard to accumulate.
Summer Intern / Berry College Student