Who’s the Greater Fool?
Ask 20 people this question, “So, what do you think about the market?” You will get somewhere in the neighborhood of 20 different replies. Ask a single economist what he thinks, and you’ll get 25 different replies as he walks you through his series of “On the other hand” statements once quipped about by President Truman. Ever been watching CNBC ahead of some big economic announcement? There are about 6 different talking heads, each with their own opinions as to what the announcement will be and what it will mean to the market. And these guys are the experts?!
Why is this so? For the most part, all 20 of your subjects will have basically the same information available to them at any given moment. Sure, some of them will follow things with the financial markets more closely than others, but in this electronic age, once news hits the wire, if it is important enough, it’s a matter of minutes, perhaps even seconds, before the news is no longer news. So, it’s generally not a matter of one person having far greater access to information than another that leads to these differing perspectives.
Well, there are any number of reasons for people having different ideas about what makes a wise investment and what doesn’t, but we might highlight what is known as “the greater fool theory”. The greater fool theory basically holds that when an investor buys a security in a transaction done at arm’s length, they are assuming that they will be able to sell the same security at a later date at a higher price than it is actually worth to a “greater fool”. The second buyer, in turn, is making the assumption that there will be an even “greater fool” in his future which will be willing to pay an even higher price to buy that same security from him. The greater fool theory is generally understood to apply only to shorter time frames, since “mispricings” tend to get worked out rather quickly in today’s marketplace.
But what does the one person know that the other doesn’t? Well, the one investor’s reason for selling might be different from the other investor’s reasons for buying. Their time frames for making their judgments as to the investment’s future growth prospects may differ, one may be hedging off risk in another portion of their portfolio, etc., but there is no fundamental reason for one investor to know with a certainty what an investment will do in the future and the investor on the other side of the transaction not to know.
So, where does this leave us? I don’t think we’ve made any major breakthroughs in financial theory here, so why bother? Simply put, nobody knows what the market is going to do tomorrow, or next week, or next year, or between now and the next election, and anyone who tells you that they do is, to be gentle, a prevaricator, an equivocator – oh, alright, they are LYING to you!!
The best one can do is to educate themselves on the market – study it, watch how it moves, learn that there are no rules for the market to follow aside from the rule that supply and demand are what drives price…period. Why does the market go up sometimes? Because there are more buyers than sellers. And when it goes down, it is because there are more sellers than buyers. And here’s the tough part – the very news which might cause market participants to want to be buyers today, could just as easily be their impetus to sell tomorrow.
Most importantly, one must expect the unexpected, and have a plan in place to implement should the unexpected occur. We believe that there are black swans out there. We evaluate each position we open with the understanding that a black swan may make its home on Wall Street for a little while without warning.
How does this impact our trading? We keep position sizes small, so we are not betting the farm on any one set of expected outcomes (our office is in an 18th century barn, so the “betting the farm” analogy really works for us!). We exercise discipline by seeking to accept only the amount of risk we feel we are being properly compensated for. We remind ourselves constantly of the danger of allowing ourselves to adopt the mindset which is along the lines of, “I am right, the market is wrong”. Well, even if we grant that you could be right and the market could be wrong (which, by the way, we are not going to grant), being right while the market is wrong will clean out your pockets for you, and it will do it quickly.
So, whatever anyone tells you about the future direction of the market is nothing more than opinion. That’s what makes the market a market. A market needs buyers and sellers to work. The only feasible way to approach generating profits in the market over the long term is to recognize this truth and to approach every single trade with this understanding – “I could be wrong”. This is an incredibly helpful assumption to have at our fingertips for those trades on which we are, in fact, wrong, and need to react, sometimes quickly. Our contingency plans are in place and are ready to be implemented quickly.
