The two theories of investing: Firm-Foundation vs Castle-in-the-Air


#1

One of my favorite investment related book is “A random walk down wall street”. In the first few chapters of that book, it presents two ways in valuating a stock.

The firm-foundation theory assumes that each stock has a true value which is equal to the present value of all its future dividends.

The castle-in-the-air theory is also known as the “greater fool” theory. It does not matter how much you pay for any stock as long as you are able to find a “greater fool” who is willing to pay more for it. It is basically saying that the true value of a stock does not matter as much as its perceived value by investors.

In my opinion, it loosely corresponds to fundamental analysis (i.e. true value) and technical analysis (i.e. perceived value). I am under the impression that many investors/traders will do both. That is, first select companies with good fundamentals. Then use technical indicators to decide when to enter/exit. Am I right? Or are you focusing purely on one thinking that the other is not important?

I am personally guilty of not putting much focus on technicals but only on fundamentals and modern portfolio theory.


#2

I guess it depends on aptitude, psychology and how is the knowledge deployed.

There are successful traders and there are successful investors.

My background is more trading inclined, trying to learn FA.

In trading, we don’t really assign a value, it would more closer to expectancy as well as market psychology. The belief would be price discounts everything (factoring sentiments) and that price is correct at any given point in time. For a specific profile of a combination of changes of price and volume, we expect a certain percentage of chance of price moving in a direction as a result. Think of it as looking at what are the crowd thinking when the chart appears that way. For example, a doji shows a clash of buyers and sellers at a point, where both sides are undecided, support/resistance are zones where for various reasons from fundamentals to a figure determined subsconsciously as a price it shouldn’t go above or below, that’s where Profit Targets and Stop Losses are placed (mental or physical). Another idea is when you see a higher price with a lower price momentum, could be more people taking profits than buying up though the small group feeble push manages to push prices up for the last time.

To complicate matters, you have timeframes, the shorter the timeframe, the less fundamentals weighs on price.

I am a believer on both FA for determining whether a stock is good to keep (not perfect at it, still learning some bits) and using TA to determine if the price is more or less at a turning point (I can safely say I can’t pick the absolute top and bottom, but rather get it when it is turning to not have the annoyance of it running down significantly much further or higher). Hopefully, by applying both, I can squeeze out gains which hopefully can compound over time.

Sorry for the long reply.


#3

For me, it is value investing. Buy businesses with excellent track record and good predictable earnings. To give away the bird in my hand, I must be sure there are 2 in the bush and know when they will come out. I don’t know how to invest by hoping or praying someone is willing to pay more than me at a later time. It might work wonders for others, but TA is not for me.


#4

I mixed both together. Firm foundations are stocks which I learned from big fat purse CNAV strategy. However i realized Singapore markets don’t really fluctuate much.

Thus i divide more than half of my portfolio into a US stocks portfolio where I play the greater fool theory.