Saturday, May 12, 2007

The danger of the ‘Bigger Fool Concept’

Initially people are attracted to the market because of earnings and good dividend yields. As the market moves up from undervalued to fairly valued, more and more people come into the market. The quickening of the market tempo pushes the market into the overvalued territory. It is here that a bubble is created. As the market moves up further, the bubble becomes bigger and bigger.

The magic lure of a constantly rising market soon becomes too much to resist. Now people are looking at future earnings, prospective dividend yields, and big contracts to justify buying. Little did they realize that the bubble has become much bigger and a burst can happen anytime.

In a prolong market advance, people become accustomed to the daily market rise. They soon throw cautious to the wind and start to buy in earnest. They think that with stop orders, they can limit their losses and hence only a small amount is at risk. In the meantime they can luxuriate in yielding to the herd instinct.

In real trades, stop orders may not be executed when they matter most. A suspension or sudden drop in price very much below your stop order can often happen at any time. This can inflate your limited loss to a catastrophe loss which may result in your inability to bear. And this can be disastrous.

The market gives and the market takes away. Don’t expect too much from the market if you don’t want to get hurt too deeply. The market does not owe you anything. Bet only what you can afford to lose.

When you are seduced into buying a stock you know is overvalued and hope to sell it a little higher to make a quick buck, this is a good indicator that a severe bear market is about to follow.

In the well-known philosophy called the ‘bigger fool concept’ it involves buying very date in a bull market in anticipation of a bigger fool to pay a higher price for your purchase. As the stock changes hands, the price hastens to the ultimate top. Eventually the person holding it finds that there is no one willing to pay a higher price for it. Thus if you do not find someone willing to pay a higher price for an overvalued stock, you must quickly sell it at a slightly lower price. Had the poor souls who bought Hwa Tai in 1997 at 200 sold it at 180, he would not have to ‘cut his limps’ when it subsequently dropped to below 3.

This blog disclaims all liability for your perusal of the above article. Whatever action you take, intelligent or otherwise, you do so at your own risk absolutely.