All Investors are Fools, only the Lessor Ones Win!
September 26, 2011
Stocks are cheap and yet they are falling. Investors aren’t buying the cheap stocks. There are unconfirmed reports that some option traders in New York and London are buying puts in massive quantities and selling calls even though markets have fallen by almost 20% from their peaks. Why? For the past couple of months,in numerous discussions, news posts and research reports we have heard equity analysts talking about the fact that stocks are really cheap, by this measure or that. Yet globallystocks have been almost in a free fall. If stocks are cheap then why aren’t investors buying them? Why are investors still selling stocks?
I mentioned this point to Justin P. the other day and he said, “Well, after all that guy, Keynes got it right. All investors are fools, only the lesser ones win. As for selling stocks right now, what can I say, there’s always a fool on both sides of the market. This is the other side of The Greater Fool theory”.
Maybe, today an investor is selling a stock despite the free fall because he thinks that after ten days or ten weeks or ten months there would be some other investor in the market – a bigger fool than him – from whom he would be able buy the same stock at a lot cheaper price and make a tidy profit. An option trader is buying puts and selling calls at expensive levels of volatility, knowing fully well that the this difference in vols is not justified by the distribution, because he is confident that very soon someone will panic and buy the puts from him at even more expensive levels.
And then Justin told me about the imaginary beauty contest that was first thought of by John Maynard Keynes.
Say, there’s a beauty contest and it will be won by popular vote. All voters, you and I, would be voting in with their favourite choice. The contestant with the most number of votes will be declared the winner. However, this is a different kind of a beauty contest. In this contest, there is a voter’s prize. All those people voting for the winning contestant will also be eligible for a prize while others who vote for the losing contestants will get nothing. Clearly, the contest now is no longer fair. Everyone would want to vote for that lady who has the highest chance of winning due to popular votes. Everyone, you and I included, would be trying to guess which contestant would be most liked/voted by others and hence would have the highest chance of winning, rather than trying to figure out who do we find the prettiest. The contest, as far as each voter is concerned, is no longer about finding the prettiest face but about finding that face which most of the others will find pretty and vote for it. A voter completely ignores the face that he finds pretty and searches for that face which has the highest chances of getting other votes. The voter’s prize completely changes the complexion of the contest.
Keynes thought that stock markets are like such a beauty contest. Investors are constantly searching for the stock which is liked by other investors and hence investors are always guessing (rather than analyzing) which stock is being bought by other investors and hence has the highest chance of going up. Rather than looking for value in stocks and buying them on their own merit, investors try to figure out which stocks have the highest chance of going up because others are buying that stock and then they buy those stocks.
Keynes wrote, “It is not a case ofchoosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even thosewhich average opinion genuinely thinks the prettiest.We have reached the third degree wherewe devote our intelligences to anticipating whataverage opinion expects the average opinion to be.And there are some, I believe, who practise thefourth, fifth and higher degrees”. Now think stock markets.
Throughout the dot com book investors bought internet stocks even though many of them were way too expensive by all measures. The NASDAQ kept hitting new highs and investors kept pouring money into internet stocks. The same happened between 2003 and mid-2007. The stock markets were in a state of frenzy and kept going higher and investors kept buying stocks, up to the very last moment. It didn’t matter whether stocks were expensive; all that mattered to any investor was whether others were buying the stocks.
The above market behavior conformed to what has now come to be known as The Greater Fool Theory, also invented by Keynes.Keynes took theabove mentioned imaginary beauty contest analogy one step further with his Greater Fool theory. Simply put, this theory states that “value” of an asset resides in the fact that someone else will end up buying the asset off you at a higher price. It does not matter how expensive an asset is. If someone is willing to pay a higher price for this asset in the near future then it is worth buying it and holding it. There were instances in Hong Kong in 2007 and 2008, when investors of all stripes would walk up to private banks and ask them to open an account for them and buy financial derivatives like accumulators or some other exotic, highly toxic product. This is because their buddies had bought accumulators in recent months and profited from it. When a couple of banks tried to reason with these investors that the Hang Seng Index was trading at a level that was unsustainable and hence buying financial derivatives with short (sell) put options embedded in them would be very risky, these investors were unfazed and ignored the banks’ advice. Their rationale was everybody was that buying stocks and hence the index level was immaterial. And sure enough, the next day they would wake up and see Hang Seng Index hitting new highs. The game went on pretty well until of course, the lesser fools bailed out.
An investor buys an asset because he thinks that it will go up due to buying by other investors and someday – in the near future – somebody will come and buy the asset from him. He is prepared to pay the extra price over and above what the “true” value of the asset today because he believes that tomorrow somebody else will pop up who will be willing to pay a higher price for this asset. Similarly, some investors may be willing to sell an asset today because he thinks that very soon another investor would pop up who would start selling the same asset a much lower price and he can then buy the asset off him and thereby make a profit.
Many seasoned hedge fund managers and option traders have deep rooted belief in The Greater Fool theory and the notional of conditional probability. They believe “value” of an asset is conditional on the most recent information received from the market. They would buy expensive put options – as perhaps they are doing now – and warehouse expensive trades because they believe that soon a coutner-party will arrive who will relieve them of the asset at a more expensive price.
Reference: Keynesian Beauty Contest and The Greater Fool Theory by Manshu at One Mint (www.onemint.com)
Keynes quote taken from: http://www.hss.caltech.edu/~camerer/Camerer%20Feature.pdf
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