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.

Regional vs Local Stability in Investment

Note: This post is a continuation of the ideas presented in Horatiu Ferchiu's "Investment as localized panacea or growth opportunity?" article.

We learn from basic economic theory, often taught in first-year university students, that stability is a good thing. Without a stable political regime, a country cannot progress as people will be reluctant to invest if they believe that they might lose their money. What this theory does not directly tell us is that an investment opportunity can never be safer than the country it is in, if one has a look at the three ratings agencies. For example, the ECB (and the EFSM/ESM funds) now enjoys a AAA rating by Moody's Analytics. If this rating falls to AA then no country in the Eurozone should have a greater rating than that. 

What does this has to do with investing? Basically, it has everything to do as it encompasses both the regional and the local element. This can be viewed more clearly if one has a look at the United States: will an investor feel the same if he puts his money in bonds issued by the federal government than if he puts it in bonds issued by one of the states comprising it? The answer would be a definite no. How about if one was to choose between investing in New York and Kansas? Definitely not the same feeling is it? The same line of reasoning can be used to explain why Greece suffers from lack of investments and the Northern countries do not. 

The question of whether the EU can do something about this is ambiguous. As stated in Horatiu's article, the issue becomes whether the EU can (or should) interfere with the internal politics of each Member-State. Many may claim that this already occurs since EU laws have supra-national power. Yet, this is totally different. What makes a country stable is not the availability or passing of laws but their actual enforcement. At another level, corruption, ease of doing business and availability of funds and potential customers are also very important. The above all can be summarized in one word: mentality.

It is not that the people in Germany, Finland and Austria think that much differently than the people of Italy, Spain and Romania. They all think about their job, money, education, love affairs, food and so on. What makes the difference between a Dutch and a Cypriot though is the expectations they have on the conduct of business in their country. If the latter believes that finding cash, resources or potential customers is extremely difficult then this will be visible to any foreigner who wishes to invest in his/her country. Now the big question is: can we change this?

The answer is unfortunately not simple. What is more not all regions are equal even if all the aforementioned barriers have been overcome. For example, an area in Germany can be much less developed than another (the former East Germany comes to mind). Yet, this does not mean that things cannot be improved. It just means that inequalities will always exist between regions are they always exist between people (think about a different people's abilities in sports, arts or other subjects for example). Any effort for changing the current state of affairs will, as always, face the resistance of those who are unwilling to change. People do not change as fast as other factors of production.

The only chance to promote additional investment to under-performing areas is to make the returns to these investments more lucrative than elsewhere. To do that we have to make sure that investors know about this and do not see a chance that their money will be permanently lost; at the same time we should not forget that one investment usually brings more in. An increase in the projects funded by the European Investment Bank could probably help, yet with an increase in these projects some are bound to turn out to be unprofitable which would render the institution less willing to fund any more. Thus, the golden mean between no investment and enough investment to initiate an investment cycle should be found.

This is obviously a non-exhaustive proposal of possible things that may be done in our region in order to boost investment. The issue of growth is not one which can be taken lightly. Yet, as we emphasize in other issues now (austerity for example) this is unfortunately left behind.

Investor Pessimism

Lately, I have been reading a lot about investors, banks and nations preparing for the worst case scenario. It seems that the definition for "worst case scenario" differs from time to time: a Greek exit, a Euro collapse, a banking collapse, a Eurozone collapse and so on. Obviously one has to prepare for such events. What I always thought to be weird is that people always prepare for "worst case scenarios" only after recessions or severe economic blows occur. One should never be worried by pessimism or optimism in the markets. Although they may last long in many cases, they are always alternating. They are both outcomes of human nature, a sort of behaviour that was the same throughout the years.

All of the great investors throughout history understood this. People are always prone to good or bad feelings. A bear market (e.g. a falling index in the stock exchange) occurs when people feel overly pessimistic about the present and the future and a bull market (the exact opposite, a rising index) occurs when people feel overly optimistic about it.

A great example of this is the banking situation nowadays. Banking institutions after expanding rapidly in the last decade (overly optimistic) are now contracting their business operations to operating only at the local level (overly pessimistic). Cross-border lending is steadily declining in the EU reaching 2007 levels in last June. Otmar Issing, a former ECB chief economist states: "Over the long term, the monetary union can't be maintained without private investors,because it would only be artificially kept alive." While this is true and many feel that getting rid of their assets in euros and buying gold or real estate is a great idea, others have gone even further by removing themselves from the monetary zone. 

Many investors are even betting against the euro surviving. John Paulson, who made billions shorting (i.e. selling something now - e.g. a stock or a currency - in hope of buying it later at a lower price and thus profiting with the difference) during the sub-prime lending crisis in the US and the now retired George Soros stated that they are betting against the common currency. 

As for me, I wouldn't worry about bank contraction. Both economies and firms contract and expand as they react to the general feelings of threat or hope for the future. A crisis is a good opportunity for people, firms, economies and states to learn from their mistakes. What I hope is that politicians and policymakers will realize the need for action. Even late action is better than no action, however too late would mean the end of the euro as many investors prophesied.