Federal Reserve System

Market Theories

Investments Seminar

Table of Contents

Introduction 3

Castle in the Air Theory 3

Firm Foundation Theory 3

Effects of the Market 3

Market Theories 5

The Tulip-Bulb Craze 5

Today's "Tulip-Bulb" Craze, the Dot-Com Crash 5

Conclusion 6

Introduction

Castle in the Air Theory

The Castle in the Air theory was introduced by John Maynard Keynes, an well known economist and successful investor of the 1930s. It was Keynes' theory that the keys to investing came from supernatural or psychic means. He applied psychological rather than financial principles to the study of the stock market. He believed that it was not only too difficult but also quite time consuming to determine the intrinsic value that would yield a promising return on investments. He thought that it should not take all of that. He proposed that the best way to do so was estimating which investment situations that the public would focus on and then buying "before the crowd." In other words, instead of picking out six out of a hundred stock based on how attractive they may have looked on the outside, it was better to select those stocks that the public were more likely to like the best. Or more so to predict what an average opinion of the best stocks are likely to be.

The Castle in the Air theory speculates that an investment is worth a certain price to a buyer because the buyer would expect to sell it to someone else at a higher price. And the new buyer anticipated the same thing. Keynes' approach did pay off for him during the Great Depression. He became famous by playing the stock market from his bed for half and hour each morning and became quite successful. While other investors were struggling to find out the financial magic number of the best investment, he simply anticipated their next move and bought before anyone else. In the text, this theory was also named the greater fool theory because it proposed that there was a sucker born every minute. These "suckers" existed to buy an investment at a higher price than what was paid. The behaviors of the masses as well as the behavior of the economy could be observed and speculated in such a way that it would bring on profits for followers of this theory. Psychologically it is to me a crude one, but perhaps it was also a truthful one.

Firm Foundation Theory

The firm-foundation theory speculated that each tool used for investment (stock, real estate, etc.) was directly related to intrinsic value. Intrinsic value could be determined by carefully analyzing present-day conditions and future speculations. It was determined that when market prices fell below or rose above this firm foundation a buying or selling opportunity would come about. Quite simply it became a matter of comparing the actual price with its "firm foundation" of value. As stated in our text, the classic developer of this technique came from John B. Williams, a mathematician and financial writer. Williams' formula for determining the intrinsic value of stock was based on dividend income. He introduced the concept of "discounting" in order to determine this value. It was his belief, according to our text, that the intrinsic value of a stock was equal to the present or "discounted" value of all of its future dividends. In other words a stock's value should be based on the earnings a firm will be able to distribute in the future in the form of dividends. At this point, future expectations have to be included which would of course entail more intricate calculations. The overall issue with the firm foundation theory, as pointed out in our text, is that it relies on difficult forecasting towards the extent and duration of future growth.

Effects of the Market

Overall all both of the above mentioned theories have aided somewhat with the stock market. The firm foundation theory seems to be way too complicated to try to figure out. But considering that it is one of the ways the Warren Buffet uses, leaves room to believe in the concept to be perhaps more accurate and predictable than most. As far as the Castle in the Air theory, it seems to be a more pleasant and easier approach. However, with both concepts it would be foolish to try to actually swear by one. I think that each one may have its good side at different moments of the market and not so great moments at other times within the market. I believe that all of this is due to the simple fact that there is no real way to predict or calculate the actual effects of the market. However, I do believe that in order to get any kind of return you will have to speculate or calculate something. It is really a matter of risk. Because in order to get any type of a return at all some risk has to be taken. Risk must