Mr. Moderate

There is in investing something called the Greater Fool Theory:

A theory that states it is possible to make money by buying [things], whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who is willing to pay the higher price.

As the above-cited web site notes:

Unfortunately, speculative bubbles always burst eventually, leading to a rapid depreciation in [] price due to the selloff.

Smart investors will always pay attention to “the fundamentals” of any given investment. That comparison is supposed to keep a smart investor from throwing money away on a “Greater Fool” investment. If an investment has “good fundamentals” that is supposed to mean that it is less susceptible to a loss of value during a market downturn since those “good fundamentals” represent better future economic prospects than would an equivalent investment with “bad fundamentals.”

While the above commentary generally represents good advice to investors, it is not a hard-and-fast rule for gaining wealth and avoiding poverty. The difficulty here is that what constitutes “good fundamentals” is only a relative comparision between two different possible courses of action, both of which might easily be fraught with danger. In other words, even an investment in an asset with “good fundamentals” can still amount to a dependency upon a “greater fool” coming along to take a bad investment off your hands at a profit for you.

What usually gets ignored, at least by unsophisticated investors, is the whole matter of market psychology:

The overall sentiment or feeling that the market is experiencing at any particular time. Greed, fear, expectations and circumstances are all factors that contribute to the group’s overall investing mentality or sentiment.

These are emotional reactions, and they are generally driven by information, which information might be either true or false, short-lived or long-running, etc. Greed will tend to drive market prices up as an underlying bias, but that bias is limited by the Law of Supply & Demand. On the other hand, if the seller has a monopoly on the sale of the item or items in question, then the price will tend to get very-much higher, very-much more quickly, depending upon the true need among the buyers for these item(s). In other words, the price will, once again, be controlled by the Law of Supply & Demand, but as mediated by the “elasticity of demand” (which is largely a measure of how “necessary” any particular good or service is to the buyers as a group) discussed in that article. As I noted in the article on Inflation & Money Supply, inflationary forces are largely a matter of the psychology of the buyer population in the market. So, too, even in the absence of inflation (or its converse, deflation), in the absence of substantial changes in the supply and demand for any particular good or service, changes in price are largely due to changes in the psychological outlook by the prospective buyers who become more or less willing to accept a different price (higher or lower than the previous or “traditional” price).

In turn, the psychology of the buyers and sellers participating in the market can be easily influenced by flows of information, which can include matters specific to the transaction in question (a pending change in the tax laws applicable to a particular transaction, for instance) or general matters that people might believe will influence the future direction of the market (violent acts; states of war or peace; etc.). And again, these information flows can operate for shorter or longer periods of time, with commensurate impacts on the price of whatever it is that is under consideration for purchase or sale.

The recipe for obtaining great wealth has long been the same: buy low and sell high. As marketing methods have gained in sophistication, we now recognize that all we need to do to have a successful business is to keep the buyers and sellers ignorant of each other, and to use the psychology of the marketplace to create a vast disparity between the buying and selling prices. The people who do this most successfully end up owning the item(s) in question for such a brief moment in time that they are called “flippers” since they “flip” from buyer to seller in little-to-no time at all. But, frankly, it is the motive of any business owner to minimize costs (including both labor and material costs) while maximizing the selling price. Both objectives involve the use of psychology to manipulate opinions about the value of what is being acquired (labor and materials) and sold (goods or services). In essence, then, all business profits are based upon an endless supply of “greater fools.”

For most families in the United States, the greatest storehouse of value that the family possessed was the ownership of their own home. If the value of that home went up, the family felt “wealthy” on that basis. And of course, they would be deluged with offers of credit based upon the increased value of the home by businesses that wanted to “suck out the equity” of these homes for their own profit (often earning huge fees for originating refinancings or second mortgages under terms and conditions that were highly-unfavorable to the home owners). The homeowners would then spend the proceeds of their new-found wealth in various ways, which would prop up other areas of our economy. But of course, all that wealth was based upon the presumption that there would always be a “greater fool” out there who would pay the artificially-inflated price for the used home. This mass psychology has led to the infamous housing bubble phenomena in US housing prices. Unfortunately, housing bubbles “may be definitively identified only in hindsight, after a market correction.” As the graph in that article shows, Japan clearly had such a housing bubble from about 1980 to the early 1990s, and would appear to have now largely experienced its market correction. The huge upward spike in US housing prices appears to have begun in about 1995 and would appear to have just recently closed in on a peak equivalent to the topping-out of the Japanese market about 15 years earlier.

The housing bubble is largely explained, in my opinion, by the fact that the great mass of the American public has been convinced to make decisions on purchasing and financing home ownership that were not, in retrospect, at all rational. The decisions made would appear to have been made upon some anticipated repeat of the inflationary spiral of the late 1970s, and that has obviously not (yet) occurred. In fact, the one government agency which appears to have learned something significant from its history during the 20th century is the Federal Reserve, the overall manager of monetary policy within the United States. It appears to be strongly biased against a repeat of the inflationary spiral of the late 1970s, and so there is no good reason to believe we will experience those same economic conditions again.

But just as the US Army appears to always gear-up to re-fight the last war better, so too the American public appears to have positioned itself to make out better during the last big inflationary cycle when there is no good reason to believe that cycle will repeat itself. A huge inflationary cycle would allow home owners to be much better positioned with respect to the payments due on their home mortgages, but it would not do much at all to help the rest of the economy.

So, not surprisingly, it appears that the sharp-dealing mortgage lending businesses have made out like bandits, gaining vast amounts of wealth at the expense of those who have invested in the “mortgage-backed securities” which get packaged full of loans about to lose value, as well as the poor home owners who will necessarily lose their homes to foreclosure when the payments get to be more than they can bear. Like any speculative bubble, the US housing bubble is all based upon the “greater fool theory” and at some point you always run out of “greater fools” who can afford to take on the increased risk while paying you your profit.

At the end of the day, it all boils down to psychology. If you can keep convincing “greater fools” to show up at your door, you can keep “flipping” real estate for profit. When even the best psychological argument won’t yield enough “greater fools” to come to your door, then it is time for the bubble to burst and reality to take over. A down market will run off the “greater fools” for a long time into the future. And at that point, like any game of musical chairs, some people are just going to get stuck owning property that isn’t economically-beneficial for them to own. They will be “stuck,” and some portion of them will fill up our bankruptcy courts for the next decade or so. Of course, Congress has done everything it could to discourage the use of bankruptcy to get out of credit card debt. But those changes generally don’t apply to being “upside down” on real estate, so we will probably see some growth in Chapter 7 liquidations after a generally-down year.

And if you want my advice on getting rich, it is “buy low, sell high, and keep your eye on the fundamentals!”