How the Water-Diamond Paradox Helps Explain the Subjective Nature of Investing

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The famous philosopher Adam Smith, best known for his classic work The Wealth of Nations, came across a perplexing paradox. Smith noted that the value of water, from a survival standpoint, is infinitely higher than the value of diamonds. Diamonds will not help you survive while stranded on a desert; water will. Therefore, when it came to the use-fullness of water vs. diamonds, it was a no contest: water always won. Yet, when it came to the price of water vs. diamonds, the opposite was true: the perceived value of diamonds was much larger than that of water. Price, of course, was the measuring point at which to measure value.

So how could it be that, while water was incredibly more useful from a survival standpoint, diamonds were priced, and therefore "valued", much higher?

The Water-Diamond Paradox Explained

The universal definition of value is defined by the laws of demand versus supply.  In the world of investing, for instance, economists will state that the price of a stock is determined by the demand and supply of the stock. In theory, this is an objective definition. It essentially states that determining the value of a stock is an exact science. Simply calculate the totality of the demand for a stock, plot it against the supply of the stock, and voila: the price of the stock results.

But Smith took this a step further. In order to understand the Water-Diamond Paradox in more detail, Smith concluded that there were two methods to define "value". The first measured the utility of the two goods. Without being able to exchange it, how useful was the good to the user? By this definition, a diamond was almost worthless in comparison to water. The value of a diamond has almost nothing to do with its utility value, while the value of water is completely determined by its utility. But, as we know, the price of diamonds is much higher than that of water. And here, Smith argued, was where the second definition of "value" holds sway: value is also be based on the "exchange value" of the good. The "exchange value" of a diamond is much, much larger than the exchange value of water (can you imagine trying to exchange a diamond for water?)

But what's fascinating is that the utility value of a good is  inversely correlated with its exchange value. In other words,  the items that have the highest price in the market are the least useful to you, assuming you cannot exchange the item. The items that have the highest price have the least utility value to you.

And if you think that is bizarre, you are not alone. The value of an item, it seems, is a function of both its utility and its exchange value. And this is where the subjective nature of value takes form.

The Subjective Nature of Value: How it Applies to Investing

Adam Smith looked at the Water-Diamond Paradox and realized that calculating the value of an item was not an exact science. The idea that there is a subjective component associated with value is a difficult idea to digest. With the stock markets, we want to believe that the price associated with any trading product is a function of fundamentals that we can objectively quantify. If a stock is trading at, say, Rs. 500 per share, analysts tell us that all information about the stock has been "priced" in, and that this information is freely available, which results in the stock trading at Rs. 500. But using the classical example of how value is derived, there will always be another element- a subjective element- that gets factored into any price of any trading product.

A perfect example of how much influence the subjective element can play is by looking at how art is valued. Is there an exact science behind how a painting gets valued? The subjective nature of value permeates everything around us. Take gold, for instance. Out of all the periodic elements, gold is the only element that meets the perfect blend of all requirements to maintain high value. Gold cannot be reproduced, which makes it a scarce commodity. But it's important to note that it's not too rare, unlike, say, platinum. Gold also has a low melting point, which makes it excellent to convert to currency, jewelry, etc. The ultimate selling point comes from the fact that gold, unlike silver, does not tarnish. This is why gold has withstood the test of time.

Gold is a perfect example of a commodity that, due to the overwhelming number of objective reasons for why it should maintain high value, subjective influences are minimized.

Apply the Gold Standard!

How should we apply this knowledge to the world of investing? By applying the "gold standard" to anything you purchase (or sell short). To minimize the subjective elements that might influence a stock's price, look for stocks that meet the "gold standard" requirements that maximize the objective components. Specifically, when you're looking to invest in a company for the long(er) term:

  1. Gold is impossible to reproduce. How easy is it for a competitor to enter the market and reproduce the business model of the company?
  2. Gold is malleable, meaning it can break down into any form or shape. How expandable is the business model of the company to allow it to easily foray into different sectors and diversify its revenue sources?
  3.  Gold has withstood the test of time. How long has the company been around? The shorter the time frame, the higher the risk associated with it.
  4. Gold cannot be tarnished. In the financial world, an analogy would be to look at the company's management. How fundamentally sound is the management? How likely is it for the company's reputation, brand, and image to be "tarnished"?

You can apply this type of screening to any trading product, whether it be Equities, Currencies, Commodities, etc.

By understanding that there is a subjective element behind the value of everything- including equities- it becomes easier to understand how certain companies are valued higher and lower than others.

And that just might be what you need to get an edge over your competition.



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