Monday, May 07, 2007

The Greater Fool Theory

To carry on the theme of value investing, we now come to the famous (now more likely labelled "notorious" !) theory called the greater fool theory. What exactly is this theory and how does it apply to investing ?

Simply put, the greater fool theory states that somewhere in the world, there is someone who is a big enough idiot to want to buy something from you at an even higher price than what you bought it for. So if what you bought is considered expensive, then that person is willing to buy it over even more expensively. Either he is very dumb (hence, greater FOOL) or he is very rich. Either way, the vicious cycle is doomed to continue because the person who bought it more expensively will choose to unload it to the next unsuspecting victim at an even loftier price. This cycle goes on and on until, finally, the greatest fool is the one left standing with an (almost) worthless item at which he paid exorbitant prices for, and which he is unable to unload to any more unsuspecting "victims".

So that's the background, but how does it apply to investing ? Well, in most bull markets as well as bubbles, traders, gamblers and speculators chase up certain stocks to fantastically high prices, with the hope of unloading it at even more fantastic prices to someone else. In essence, the Greater Fool theory is a case of "buy high, sell higher"; which violates the basic principle in investing which states that we should "buy low, sell high".

Note that when I say "low" and "high", I am talking in terms of valuation, not absolute price. Most traders pile on the penny stocks because they seem cheap in comparison to blue chips; but that's only looking at absolute prices. Some of these seemingly "cheap" stocks actually have little to no earnings, and most are in the red; thus justifying their penny status. Companies with solid foundations like DBS, SPH, UOB and other blue chips are able to hold their own and justify trading at PERs which reflect their earnings and growth. In contrast, companies with no earnings seem to be perpetually issuing rights and doing share placements in order to raise ever more funds which eventually end up being sucked into one BIG BLACK HOLE (I won't name such companies, but the discerning reader should be able to tell which are the ones).

Thus, people who buy high in order to sell higher run the risk of ending up being the greatest fool, especially when the party is over. Recall Benjamin Graham's margin of safety which states that stocks should be purchased at a discount to their intrinsic value, in order to give an investor a safety "moat", such that even if he is proven wrong, his loss is minimal. By buying a stock as it is zooming up, we are ignoring the principle of margin of safety and are entering the realm of speculation which is akin to gambling. Warren Buffett further asserts that the dumbest reason to buy a stock is because it is GOING UP !

What this post strives to tell the reader is this: do your homework, analyze rationally and invest objectively. Never chase hot tips and unfounded rumours in order to "make a quick buck". Most times, you end up losing your pants or half your shirt !

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