CAT Model Paper 3 Questions and Answers with Explanation Part 6

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Directions for questions 31-34: Read the following passage and answer the questions given below it.

The castle-in-the-air theory of investing concentrates on psychic values. John Maynard Keynes, a famous economist and successful investor, enunciated the theory most lucidly in 1936. It was his opinion that professional investors prefer to devote their energies not to estimating intrinsic values, but rather to analyzing how the crowd of investors is likely to behave in the future and how during periods of optimism they tend to build their hopes into castles in the air. The successful investor tries to beat the gun by estimating what investment situations are most susceptible to public castle-building and then buying before the crowd.

According to Keynes, the firm-foundation theory involves too much work and is of doubtful value. Keynes practiced what he preached. While London’s financial men toiled many weary hours in crowded offices, he played the market from his bed for half an hour each morning. This leisurely method of investing earned him several million pounds for his account and a tenfold increase in the market value of the endowment of his college, King’s College, Cambridge. In the depression years in which Keynes gained his fame, most people concentrated on his ideas for stimulating the economy. It was hard for anyone to build castles in the air or to dream that others would.

Nevertheless, in his book The General Theory of Employment, Interest and Money, he devoted an entire chapter to the stock market and to the importance of investor expectations. With regard to stocks, Keynes noted that no one knows for sure what will influence future earnings prospects and dividend payments. As a result, Keynes said, most persons are “largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.”

Keynes, in other words, applied psychological principles rather than financial evaluation to the study of the stock market. He wrote, “It is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.”

Keynes described the playing of the stock market in terms readily understandable by his fellow Englishmen: It is analogous to entering a newspaper beauty-judging contest in which one must select the six prettiest faces out of a hundred photographs, with the prize going to the person whose selections most nearly conform to those of the group as a whole. The smart player recognizes that personal criteria of beauty are irrelevant in determining the contest winner. A better strategy is to select those faces the other players are likely to fancy. This logic tends to snowball. After all, the other participants are likely to play the game with at least as keen a perception. Thus, the optimal strategy is not to pick those faces the player thinks are prettiest, or those the other players are likely to fancy, but rather to predict what the average opinion is likely to be about what the average opinion will be, or to proceed even further along this sequence. So much for British beauty contests.

The newspaper-contest analogy represents the ultimate form of the castle-in-the-air theory of price determination. An investment is worth a certain price to a buyer because she expects to sell it to someone else at a higher price. The investment, in other words, holds itself up by its own bootstraps. The new buyer in turn anticipates that future buyers will assign a still-higher value. In this kind of world, there is a sucker born every minute and he exists to buy your investments at a higher price than you paid for them. Any price will do as long as others may be willing to pay more. There is no reason, only mass psychology. All the smart investor has to do is to beat the gun, get in at the very beginning. This theory might less charitably be called the “greater fool” theory. It’s perfectly all right to pay three times what something is worth as long as later on you can find some innocent to pay five times what it’s worth.

Q: 31. What does the author mean by †this logic tends to snowball?

(A) The reasoning that it is better to select what others select backfires

(B) The reasoning that one should select what others are likely to like, puts into action a sequence of similar reasoning which gathers momentum

(C) The reasoning that one should try to predict what the average prediction about a certain prediction is likely to be, is the best one

(D) The reasoning which is based on mass psychology about what would be the general prediction is optimal.

Ans: B

Solution:

The lines “A better strategy is to select those faces the other players are likely to fancy. This logic tends to snowball. After all, the other participants are likely to play the game with at least as keen a perception” clearly shows that the logic works on cumulative selections which keeps growing bigger and thus leads to the optimal outcomes. To snowball means to accumulate gradually into something big.

Q: 32. Which of the following best paraphrases the concept of castle-in-the-air theory of price Determination?

A) An investment is worth paying for if there is a fool waiting to buy that investment

B) It is irrational to buy something at a certain price if it is considered high by market standards

C) Whatever be the cost price of an investment, it is justified if one understands mass

Psychology

D) There is no upper limit to the price of an investment as long as there is a growing market for that investment

Ans: D

SOLUTION

The line “It’s perfectly all right to pay three times what something is worth as long as later on you can find some innocent to pay five times what it’s worth.” Indicates d as the answer.

Q: 33. According to Keynes

I. The study of the stock market is a short-term phenomenon

II. Stock market changes are amenable to long term predictions

III. Understanding stock markets require the application of psychology rather than finance

IV. The market value of an investment is always higher than its inherent value

(A) I and III

(B) II, III and IV

(C) I, II and III

(D) III and IV

Ans: A

Solution:

According to Keynes, the study of stock market is “not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.” This proves (I) to be true and (II) to be false. “Keynes, in other words, applied psychological principles rather than financial evaluation to the study of the stock market.” Proves III to be true. In IV , the word “always” makes it a distortion of the truth.

Q: 34. Which of the following situations most closely follows the ―castle-in-the-air theory?

(A) A professional buying a second house hoping to sell it for a profit knowing that it is overpriced

(B) A gambler continuing to wager larger and larger sums in the hope of winning

(C) A promoter starting up a project in a remote area which reliable sources predict will take at least 20 odd years to become urbanized

(D) An investor buying up the stocks of a company which is set to secure a several big orders in the next few months

Ans: A

Solution:

The “Castle-in-the-air” theory says “An investment is worth a certain price to a buyer because she expects to sell it to someone else at a higher price. The investment, in other words, holds itself up by its own bootstraps. The new buyer in turn anticipates that future buyers will assign a still-higher value.” This logic is apt in the situation mentioned in option a . Clearly a second overpriced house is expected to fetch a higher price in the eyes of the buyer. Gambling is about chance and does not apply here. 20 years is a long term business and according to the passage the theory is mostly about short term predictions. Last option is based on financial evaluation which is not the basis of the referred theory.