The “Bigger Idiot” Principle

A while ago, somebody asked me why anyone would pay $20 a share for stock that was clearly only worth a few cents per share. Or, for that matter, why people will pay several hundred dollars per share for stocks that are only worth $20. The short answer is that stock prices are not based on the actual book value of the issuing company, but rather on what people are willing to pay for those shares. But since that answer does not really explain the situation, let’s take a closer look at it.

In theory, at least, everything has two prices: what it is actually worth, and what people are willing to pay for it. Most of the time, the item being sold has one or more intangible values that increase the selling price. For example, a meal at a fast-food restaurant may only include a few cents worth of ingredients, but it has the added value of having been prepared by someone else, the added value of being convenient, and (hopefully) the added value of tasting good. A pair of designer jeans may involve no more raw material than any other pair of pants, but may have the added values of prestige, superior comfort, or superior aesthetics.

In the case of a share of common stock, the inherent value of the share is the book value of the company that issued it divided by all of the share currently in existence. If the company is worth $100 million and it issues 100,000,000 share of stock, then each share should have a value of $1, and so on. But suppose we know that the company’s book value is about to double. That means that each share we purchase at $1 will be worth $2 in the near future. In that case, we might be willing to spent $1.25 or even $1.50 per share, even though we know it isn’t currently worth that much, because we know it will be. Or at least, we expect that it will be.

Where this sort of calculation becomes difficult to follow is when the item being sold has little or no intrinsic value, and the only added value comes from the expectation that its price will eventually rise. A familiar example from the past decade would be the Beanie Baby fad. If you missed it, in the late 1990s people all over the world were purchasing small stuffed toy animals from the Ty corporation, called Beanie Babies, sometimes for thousands of dollars, in the hopes that the price would rise enough for them to resell the toys and recoup their investment. In some cases, this resulted in collectors paying in excess of $10,000 for a toy with a retail price of less than $10 and a total production cost of well below $1.

In Business School, this was informally referred to as the “Bigger Idiot” Principle; in other words, the idea of paying a ridiculous price for something on the principle that someone, somewhere was an even bigger idiot than you and would pay an even more preposterous price for that item. If you’ve ever purchased something at a thrift shop or a garage sale that you know has no value but which you suspect you can resell for a higher price than you paid, you have engaged in this behavior. If you’ve guessed correctly, you may have netted a lot of money doing it, too.

But the problem with this business model is that eventually you will reach a price point that even a complete idiot will not pay, and since the entire market for these items depends of the price continuing to rise ever higher, once that breaking point has been reached, the market will collapse. In the case of the Beanie Babies, there have been documented cases of people losing their homes, businesses, or retirement funds when the toys they purchased at thousands of dollars each were suddenly worth their original $10 again.

The most famous historical example is probably the “Tulip Mania” phenomenon which occurred in the Netherlands in the 17th Century, during which time speculation on the future potential price of tulip bulbs began running amok. The exact impact of this disaster on the Dutch economy remains in dispute (since the country was also dealing with a plague epidemic and the after-effects of the 30 Year’s War at the time), but the similarity to the Beanie Baby boom and bust, or the Dot-com Crash a few years later, is chilling to say the least.

Speculation based on the potential future price of commodities purchased in the present is the basis for much of our free-market economy, particularly when we consider the concept of Value Added to be merely one of the factors involved in such speculation. There is no way to prevent such business dealings, and no need to do so, really; provided of course that we take care not to become the bigger idiot ourselves…