Firm Foundation vs Castle in the Sky
So… I was reading a A Random Walk Down Wall Street, which is a supposed to be a must read for most wannabes investors. One thing that really got my interest was this segment on Firm Foundation theory. vs the Castle in the Sky theory. Let’s get straight to the point:
Firm Theory: Your traditional Value Investing, proponents of Intrinsic Value. So basically, this theory believes that every investment has a sort of like a, Real Value attached to it, by looking at the Past and Future conditions. To put it in perspective, for example, when you look at a piece of 2-Carat diamond ring, how do you put actually put a value to it?(I assume that no one here is a professional ring valuer here. haha) You will have to do a basic analysis to it right? Example:
Present Condition- The cut of the diamond… the clarity…the location it found..the colour..the dealer and the designer.
Future Condition- How will the future supply looks like? Will demand increase? Will there be any political issue that affects both demand and supply? etc…
Castle in the Sky: This theory was displayed most clearly by John Maynard Keynes, a famous economist and successful investor.Basically, the believe is that people like to build castles in the sky ie. speculate. Therefore, just buy before them, and that there is actually no point in doing any sort of fundamental analysis. You must be thinking “This is not a theory! This is just pure gambling la!” Hold your horses, as this concept was displayed in a British newspaper beauty contest, where readers were asked to pick the 6 prettiest contestants out of a 100. The person who picks the closest to the other readers will get a reward. SO, this comes the main point. If you think about it, if you were to win this contest then, the main point is not to pick the 6 contestants that you think is the prettiest, but it is to pick the 6 that you think OTHERS will think that is the prettiest. So this concept goes in line with stocks and investment. By picking the stocks that you think are the best because you have done all your fundamental analysis, does this mean your investment will definitely do well? It has no impact actually in this case, as what you think does not affect the price of the investment(although you sure did affect the Demand and Supply of the investment at some point). What you have to do is get really understand what the next trend, and predict when people will start building castles, and you start building your portfolio before they even put the first brick to that castle!
So which concept is actually right?
There is no right answer in investment I guess and maybe both answers are actually right la. We all have to believe a little bit of both. I am slightly inclined to the Firm theory though. I like to liken an investment to be like a cow. Doing fundamental analysis, you will analyse the cow by it’s strength, size, current state of health etc to predict the quality and quantity of milk that you will receive right? But at the same time, you don’t really know when the next time mad cow disease may hit. When it hits, you can’t really know if your investment in that cow, will go down (because nobody dares to drink milk and eat beef) or up (because now you have the only cow left in the world and people want to drink milk or eat beef so bad), and such you really have to try to choose the consensus opinion for this.