Why Did People Buy Stocks in the 1920s?

The 1920s is the ultimate cautionary tale against speculation in the stock market and borrowing to invest. The crash of 1929 wiped out a massive chunk of America’s GDP and ultimately began the Great Depression.

The bubble that burst in 1929, though, took nearly a decade and the participation of millions of American investors to form.

Why were people buying stocks in the 1920s, and how did sensible investing turn into wild speculation?

General Prosperity Set the Stage

The first ingredient necessary for the stock bubble of the 1920s to form was excess capital for businesses and individuals to invest. The Roaring 20s provided this easily enough, with per capita income rising 31 percent between 1919 and 1929 and employment rates remaining consistently high throughout the decade.

The American economy as a whole was also historically prosperous during the 1920s. Consumers began purchasing vehicles, household appliances and other goods made possible by a combination of technological innovation and advances in mass manufacturing.

Total factor productivity (TFP) is estimated to have risen by about 84 percent during the decade, and the economy as a whole grew by 42 percent.

As a result of these economic trends, Americans found themselves with extra capital to invest and a seemingly favorable environment in which to do it. Indeed, through most of the decade, it can be argued that bullishness on stocks was largely justified.

Modern research has found that between 1922 and 1927, stock dividends largely tracked rapidly rising share prices. It was only in 1928 and 1929 that prices ran far ahead of dividend growth, suggesting that it was mostly at the end of the decade that the stock market truly became a bubble.

Stocks Suddenly Caught on Among Retail Investors

Stocks were nothing new in the 1920s, as the first trading floor, the Philadelphia Stock Exchange, began operating in 1790. Throughout the 19th century, though, stocks were mostly the domain of wealthy investors.

In the 1920s, the appetite for investment opportunities and the general success of stocks caused a massive influx of retail investing. Many of these investors sold bonds and borrowed against real estate, both well-established forms of retail investment, to get in on the stock market boom.

As one might expect, the investment industry responded to increased demand for stocks by rushing to meet it. Brokerages and investment banks sprang up to help investors funnel their money into the stock market.

The result, over time, was a mass entry of inexperienced investors into the stock market encouraged by much easier access to buying and selling securities.

Leverage Made Investing Seem More Affordable

Another factor was the advent of leveraged trading. Even with rising incomes and a generally prosperous post-war economy, most people still had relatively small amounts of extra cash to invest. Buying on margin, therefore became a hugely popular way to reap investment gains with limited money up front.

Before 1928, banks and investment houses often required margins of 10 or 20 percent, allowing investors to leverage their money by 5-10 times. Even in the lead-up to the crash, banks were still allowing 2:1 leverage

Of course, leverage proved to be a double-edged sword. For most of the 1920s, the general economic climate and a white-hot stock market made declines in share prices relatively rare.

As a result, many investors failed to properly understand the risks they were taking by trading with borrowed money. When lenders tightened margin requirements in the months leading up to the crash and stock prices began to move somewhat downward, many investors found themselves struggling to maintain liquidity. These forces eventually drove the crash as investors of all sizes failed to meet margin calls.

Fear of Missing Out Threw Fuel on the Fire

Although the term wasn’t coined until 2000, it’s hard to overstate the role that fear of missing out (FOMO) played in the formation of a stock market bubble in the late 1920s.

As early investors reaped gains, more began to pay attention to the returns the stock market was producing. This, in turn, led even more investors to jump into stocks.

In large part, this was also driven by a fear of losing savings due to new inflationary pressures. The strict gold standard that the United States had adhered to throughout the 19th century kept inflation rates near zero on average.

Inflation began to tick up after World War I as the world gradually moved toward fiat currency. As such, borrowers found the purchasing power of their savings decreasing appreciably for the first time and started looking for better ways to manage the money they saved.

Investment Turns to Speculation

It’s fairly easy to see that there were solid reasons to invest in stocks throughout most of the 1920s. In the later years of the decade, though, that productive impulse crossed a line into almost pure speculation.

In 1926, the market delivered a relatively normal positive return of 11.6 percent. In 1927, that number rose to 37.5 percent. 1928 saw even higher returns, with stocks jumping 43.6 percent in a single year. These returns were unsustainable and ultimately pushed the market deeply into overvalued territory.

Though it’s probably apocryphal, a story told about Joe Kennedy in 1929 nicely sums up the level of mania stocks reached just before the crash.

According to the tale, Kennedy, the father of later President John F. Kennedy, was having his shoes shined the summer before the crash. While performing the service, the shoe-shine boy is said to have begun giving the noted businessman and investor stock tips. Kennedy then sold all of his stocks, assuming that this was a sure sign of a market brimming over with irrational enthusiasm.

It’s also interesting to note that the phenomenon of speculative investing wasn’t limited to stocks. Throughout the 1920s, investors also bought heavily in real estate bonds to finance large-scale construction projects.

Though this resulted in a building boom, particularly of skyscrapers in large, urban areas, investors were quick to put money into real estate assets they didn’t understand well and which relied on speculative future rents to underpin their value.

Unsurprisingly, the stock market crash that happened in 1929 was accompanied by a commercial real estate crash that wiped out the value of many of these projects.

So, Why Did People Really Buy Stocks in the ’20s?

At first, the reasons for buying stocks in the 1920s appear to have been sound. The economy was growing rapidly, savings were less attractive due to inflation, rising incomes gave investors extra money to allocate productively and buying stocks became more accessible to everyday people. Under these conditions, investing was a sensible way to use extra money to build future wealth.

The problems, however, emerged later on. The influx of retail investors combined with extremely high leverage rates pushed share prices past what was justified by even robust economic growth.

By the time 1928 and 1929 came, investors were buying practically any stock they could on the assumption that prices would keep rising. Needless to say, this thinking was quickly proven wrong.

The buildup to the crash of 1929 is more than just a cautionary tale against speculation. It shows that, like many bubbles, the market of the 1920s started out on fairly sound footing. Even stocks that start out as good investments can become overpriced, leading to sudden selloffs.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.