Greater Fool Theory

Speculating in the stock market is very risky. The predicate is the Greater Fool Theory. This form of speculation requires no information or at best information based on unscientific methods of divining movements in the prices of stocks. This theory explains those buy long or sell short transactions that are initiated by someone regardless of current quoted market price for a stock who believes that there is a greater fool somewhere who will take him out of his position at a price that will produce a profit for him. No deep analysis is required.

A key question for anyone who enters the market: are you an investor or a speculator?

I am an investor. The following information comes from The Theory of Investment Value by John Burr Williams:

The Market for a Single Stock. Both wise men and foolish will trade in the market, but no one group by itself will set the price. Nor will it matter what the majority, however overwhelming, may think; for the last owner, and he alone, will set the price. The marginal opinion will determine market price.

Investors and Speculators. So far we have discussed a stock market for investors only. Bull or bear a man may be, and still be an investor rather than a speculator, so long as he looks to dividends rather than to price changes to justify the cost of his stock. There exists another large class of traders, however, made up of speculators, whose business it is to buy and sell for changes in price alone. To these speculators dividends are inconsequential because they hold for too short a time to receive many dividends.

To gain by speculation, a speculator must be able to foresee price changes. Since price changes coincide with changes in marginal opinion, he must in the last analysis be able to foresee changes in opinion. Successful speculation consists in just this. It requires no knowledge of intrinsic value as such, but only of what people are going to believe intrinsic value to be. Now opinion, when it changes, need not change for the right; it may change for the wrong, and the probability of a change for the wrong is about as great as of a change for the right. If opinion were not found in part on current dividends and changes therein, there would be nothing to prevent price and value from drifting miles apart.

How to foretell changes in opinion is the heart of the problem of speculation, just as how to foretell changes in dividends is the heart of the problem of investment.

Since opinion is made by the news, the task of forecasting opinion resolves itself into the task of forecasting the news. There are two ways to do this: either to cheat in the matter, or to study the forces at work.

Cheating has been outlawed, so far as can be, by the Securities Act of 1934, which tries to prevent insiders from gaining by foreknowledge of dividend changes, earnings statements, contracts let, etc., and requires these insiders to refund all short-term profits in their own stock to the treasury of their company. … In having access to this inside information, officers and directors have a most unfair advantage over the host of ordinary stockholders. Only stupidity or indifference, on the one hand, or great scrupulousness or recklessness on the other hand, can prevent insiders from getting rich in the market, and all that the law itself can really do is to advertise the ethics of the problem.

No one man can hope to be an expert in everything, and if he ventures to speculate outside his own special field he takes the chance of finding that he has bet not with but against the experts, for which impudence he must pay dearly.

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