Bubble pricing

Consider two stocks:

1. Trades in a range from $5 to $15.
2. Trades in a range from $9 to $11.

The not too difficult question is: which stock is riskier? And given no more information, A is the riskier stock. That's because the greater volatility means you could lose more money with A than trading in B—at least if you only had price information to work with.

But if you knew for certain that the actual value of each stock was $10, than A ought to be far less risky. Instead of trading randomly, an investor could begin buying once stock A is priced below its value and sell when the stock is above its value for a true arbitrage situation. This is Ben Graham's margin of safety principle. One little piece of information (the value of the stock) makes a huge difference.

Of course, we can never really be certain about anything, much less the value of a company that might have skeletons lurking in its metaphorical closet. The fact is, markets are often right. That's because of somewhat bizarre phenomenon known as the wisdom of crowds. In essence, the crowd is more likely than the individual to the answer to certain questions correctly if at least three conditions are true:

1. There exists a diversity of thought.
2. There exists an aggregating mechanism.
3. There exists an incentive to individuals for being right.

If any one of them is missing, an individual has a chance to do better than the crowd. But a well-designed market has all three of these conditions most of the time. Therefore, if we want to invest in stock A, we ought to make a case not only why $10 is the right price, but also why crowd wisdom doesn't apply.

A familiar case is the asset bubble. For instance, a group of investors might decide that stock A is worth $15, not $10. So they start to buy whatever shares they can lay hands on. Then some people decide the stock might be worth more like $20 and bid up the price further. The jump from $5 to $20 attracts speculators who don't know, and may not care, how much A is worth. At this point anyone who owned A and thought it was worth $10 or even $15 has taken a profit and anyone foolish enough to be short has either covered or lost their shirt. So both sides of each trade are people who believe in the company at any price. Condition I is thoroughly violated.

But there is also a problem with conditions II and III as well. Bearish opinions on the stock are not aggregated because there is no incentive to take a position. It is difficult to make money on negative opinions in the current stock market because short trading is both difficult and dangerous. The same can be said about the housing market, except substitute impossible for difficult and dangerous. Early on, when it might help with little pain, the crowd can't apply the brakes.

I've been playing the Motley Fool CAPS game and, even though I'm doing a terrible job there, I think its a pretty useful tool. Instead of judging success on an absolute basis, picks are compared to an investment in the S&P 500 over the same time period. So, a thumbs up pick might be losing even if the stock price has gone up if the index has gone up faster. If you read a mutual fund prospectus, the concept ought to be clear. More importantly, thumbs down picks win as long as the index does better than the stock.

You accomplish the same effect by selling as stock short and using the proceeds to buy an ETF that tracks the index. It would be somewhat expensive, however, since you would need to pay twice the number of commissions and there is normally a margin requirement. Perhaps some sort of ETF or derivative could be devised to solve the problem. It's also possible to simulate a relative return on a bullish position, but this wouldn't normally make sense unless you thought the index was due for a fall.