Theories of Investing

...or why every theory is a greater fool theory.

Imagine, dear reader, that you are currently thinking about purchasing a company's stock. What would your rationale for buying might be? Usual answers would be great potential for future growth, low P/E ratio, excellent management, stable growth over a period of time or a strong company record. Others may say that they have received a tip from a "good source" that the price might rise or that their charts tell them that there will be a "head-and-shoulders" recovery or their MACD combined with their 7- or 30-day average has indicated that they should do so. No matter what the approach might be, there really is just one simple reason people buy stock: they believe that the price will rise.

Some have longer horizons than others, some bet for a 1% return, some bet with high leverage; it does not really matter. Their purpose is simple and can be fully described in one word: profit. Why would any us bother to trade a stock if their was no potential of gaining something for it? There is no-one out there (I think!) who would be willing to buy a stock if he believed that the price would remain stable and he wouldn't be able to make a single cent of profit. Keeping his money in the bank, earning his meager but stable return would be a better alternative. The same holds if the stock-picker was certain he would face a loss in his investment.

I doubt that there is anyone who would disagree that people are into stocks for profits. There might also be other reasons for it, such us obsessive gambling behaviour, but this just an outcome. The only real reason everyone got involved with the stock market was profit. Note that before, my statement was "if one believed that there was no profit potential" he wouldn't bet in the market. Not if I (or any other) told John, Jack or Jill that the stock was going down and they had a different opinion; only if they believed it themselves, although someone might be able to influence them one way or another. Yet, any other person cannot trade with their money (unless they give it to him) which means that if he cannot influence them, they will continue to buy; at the same time I would prefer to sell. This is essentially what makes stock markets move up and down: differences of opinion. 

It does not really matter who is right and who is wrong when the market moves. You cannot even know who is. Just because the market has moved with you for a day does not make you right just as it does not make you wrong if the market moved against you for a day. What makes you right or wrong is whether the market moves with you or against you in the time-frame you have personally selected, no matter how big or small that might be. If your horizon is infinite, then you have less to worry about day-to-day movements, yet more to worry about longer-term ones. If it's a couple of days or hours then the opposite holds.

Then the question becomes: when do you sell? Is it just when the investment horizon hits or when the price hits a certain limit? Let's think about it. People tend to have some sort of price or return in their minds if their horizon isn't infinite (which usually isn't). Returning to the previous arguments, people always buy for a profit. But they want the profit to be substantial enough to cover their costs and gain some return on top of that. Thus, they have to at least know about the minimum price at which they will sell. How about the maximum then? If one uses more sophisticated techniques (value investing is an example that springs to mind) they can even calculate the exact price they expect the stock reach; after reaching that plateau, they will almost certainly sell it. If ones does not use any sophisticated technique then he will just sell it when his gut tells him to do so (this does not make the "gut" technique better or worse than the others).

In any case, deep down, there is only one reason for selling a security and that it that the investor believes that it has run its course, i.e. that it cannot provide him with any more profit at the time being. If an investor is asked, explanations offered may appear to be different but at the heart of every argument about the sale of a particular security is the simple notion that the investor does not expect it to provide any more profits at the time being. The stock may continue to rise or it may fall, yet this is of no meaning to the investor. He may purchase it again later if his forecast changes, but at the time of sale he is almost certain that the winning strike will no longer continue.*

Consequently, when the investor's beliefs are that the stock must be sold, it means that anyone suggesting that it will continue its course will not matter. At the time of selling, his belief dictates that doing anything else but selling would be irrational, given his knowledge and the interpretation of that knowledge at the time. Thus, for the investor, any other person acting against what he believes is nothing but a "fool". This might appear to be a rather broad generalization given that others might have better information or better understanding of the situation. Yet, the idea behind this is subjectivity. If I know something and keep on postponing my actions because I do not know what others know then I would be indefinitely postponing closing the position. This will mean that I will never capitalize on any gains which will mean that there is no point in ever opening the position. Under my subjective decision, I can only say that I am doing the best of what I can understand and have information of, which means that my decision is optimal based on what I know and understand at the time.

Thus, returning to the original argument, if an investor decides, using whatever technique or idea, that the position must be closed, any other way of acting would be foolish, including the person who buys the stocks he sells. Once again: the decision may be proven right or wrong in the future, but it does not matter. All that matter is that the investor believes it is the correct one at the time. Subsequently, when we are selling we are depending on finding a fool to buy the stock. We might have been foolish in buying the stock or we might have been clever, it does not matter. All that matters is that, when we decide to sell it, a greater fool than us will be willing to buy it. Maybe the buyer is not a fool and in the end proves to have better understanding or information. Yet, from our subjective point of view, the buyer is a greater fool since we are giving stock at a price we would consider ourselves a fool for buying.

Most critics will say that approaches like value investing are not like that. Let's think again: we have a firm with 1 million of profits selling for 9 million when we believe that the proper price would be 10 million. Thus, we buy at 9 and wait until it reaches 10 to sell. Would we have bought it at 10? No profit potential so I would assume the answer would be a clear no. Thus, for the value investor, anyone buying the stock at 10 or higher is a fool since he cannot possible get any profit from the transaction (unless information changes that is).

Summing up, it does not really matter why a person buys a stock; he wouldn't be doing it if there was no hope of profit. And if he does buy it then we assume he has to sell it at some point, whatever that point may be and no matter how many times the point is revised. When finally reaching it, the investor will sell; and from the investor's point of view, anyone else buying what he is selling, is a fool.

*It is straightforward to say that if the market turns against the investor and is forced to close his position then all of the above do not matter; leverage, willingness to hold the position despite worsening of the situation are what will define his ability to remain there.