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The articles on “The Firm Foundation Theory” and “Castles in the air Theory” in the book “A Random Walk down Wall Street” by Burton Malkiel discuss two very components of investments and financial theory (Malkiel, 2000) In the article, “the Firm Foundation Theory” the author says that any “investment instrument” can be said to have “intrinsic value” which is calculated by taking a historical perspective, that is taking into account past performance and the present situation and analyzing these to project future position.
An example of the firm foundation theory can be best seen through the analysis of stock prices.
The main idea is that the value of a stock should be based on the constant flow of earnings that a firm will be able to give out in the form of dividends. The “castle in the air” theory originally formulated by John Maynard Keynes states that investors in general do no spend their time and energy in calculating the intrinsic value of a financial instrument, be it a stock, bond or other alternative investments.
Instead, the real savvy investors, according to Keynes, prefer to spend time and energy in anticipating and analyzing how a “crowd of investors” will most possibly behave in the future.
The professional investor will try and anticipate what the crowd will do and if it seems that the crowd is optimistic and times are good, the crowd will tend to build “castles in the air”. The smart investor should try and buy before the optimism sets in so that he buys at a lower price than the general market.
The general idea regarding “firm foundations theory” in the mind of Keynes is that it is too time consuming and it is erroneous because it is not possible to accurately predict future performance by looking at past and current trends. Relations to the course
The article relates to the course in the sections on fundamental and technical analysis. Fundamental analysis is similar to the firm foundations theory. “Fundamental analysis uses earnings and dividend prospects of the firm, expectations of future interest rates, and risk evaluation of the firm to determine proper stock prices” (Bodie, Kane, & Marcus, 2003, pp. 348-349). This means that a stock’s value can be calculated by viewing past and present scenarios, and by predicting the future variables. The firm foundation theory essentially makes the same claim.
The article on Castles in the air is similar to technical analysis in the book. Technical analysis is essentially the search for recurrent and predictable patterns in stock prices (Bodie, Kane, & Marcus, 2003, pp. 343-344). Technical analysts do give a degree of attention to the value of future prospects, but they believe it is secondary in nature. Their true purpose is to analyze the trend of stock price movement. Castles in the air theory also supports the trend aspect of technical analysis and believes in looking at the “crowd of investors.
” William Neil mentions that profitability is one of the most crucial factors to determining stock price (Neil, 2000). So for an investor to earn capital gains and dividends it is necessary to look at items that show positive earnings. This is one of the most essential ideas of fundamental analysis. (Neil, 2000), goes on to say that in technical analysis, the use of charts is very important as charts show the trends much more effectively than figures do. Personal Reflections and Comments
“Firm Foundations” and “Castles in the air” are very important and relevant theories in the field of investment. This article has helped me gain a better understanding of how to invest and what are the most important criteria of investments.
Bodie, Z. , Kane, A. , & Marcus, A. (2003).
Investments, Fifth Edition. McGraw Hill/ Irwin. Malkiel, B. (2000).
A Random Walk down Wall Street. W. W. Norton and Co. Neil, W. (2000).
24 Essential Lessons for Investment Success: Learn the Most Important
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