When it comes to selling an asset at a higher price than it’s truly worth, there’s always a fool who will buy it. That, in essence, is the greater fool theory. In a nutshell, it states that investors can sell any asset at an inflated price, so long as they can find a “greater fool” who will pay it.
The greater fool theory is a short-term approach to investing, and it’s by no means a fundamental law. Let’s take a look at this theory and see where it holds up and where it falls short.
What is the greater fool theory?
The greater fool theory is the idea that investors can achieve positive returns by purchasing assets (such as stocks, cryptocurrencies, or even real estate property) and selling them at higher prices without concern for the asset’s true value.
In other words, it doesn’t matter what the asset is really worth. The asset could be a stock whose underlying company has a flawed business model, or it could be a home with a leaky roof and a faulty foundation. So long as there’s enough hype around the asset, the greater fool investor assumes they can find someone who will pay a higher price.
Greater fool investors are often contrasted with value investors. A value investor uses fundamental analysis to identify stocks that are trading below their true value. The idea is that by buying stocks at a discount, value investors achieve positive returns when the market recognizes the stock’s true worth.
Greater fool investors rarely use fundamental analysis to evaluate a stock. Their approach is more subjective. So long as they can find a buyer willing to pay a higher price, they’ll invest in the asset, no matter how much the asset is truly worth.
The greater fool theory isn’t limited to investments, however. Any commodity can show the greater fool theory in action. In fact, one of the clearest examples of the greater fool theory is new technology. Often, when new technology is released in limited quantities, it intensifies demand among consumers. Certain savvy consumers might then buy new technology at a list price, then turn around and sell it at a higher “street” price.
Does the greater fool theory work?
The greater fool theory does not always work, and it can come back to haunt the investor, should they fail to find a buyer for their overvalued asset (thus becoming the greater fool themselves).
In order for the greater fool theory to work, there needs to be a sufficient amount of build-up around an asset. In other words, there need to be a lot of “fools” who will pay a high price. If there is, these fools likely won’t pay attention to the asset’s true worth. They’ll ride the momentum, paying the higher price simply because there’s enough demand around it.
Of course, at a certain point, investors will catch on to the inflated price. After all, not everyone is a fool. And if the tide turns against an asset, if investors begin to refuse to pay high prices, the asset’s bubble will burst. At that point, whoever paid the highest price will be the real fool: they’ll have to sell it for a lower price, thus taking a loss.
When Does the greater fool theory apply?
The greater fool theory applies in various instances, primarily within financial markets and investment strategies. Here are a few instances where the theory often applies:
1. Speculative Bubbles: During speculative bubbles, assets can become highly overvalued as buyers continue to purchase them with the expectation that they can sell them at even higher prices. This cycle continues until there are no longer any buyers willing to pay the inflated prices, leading to a rapid decrease in asset prices. The dot-com bubble of the late 1990s and early 2000s is a prime example, where investors kept buying overvalued tech stocks believing they could sell them at a higher price.
2. Real Estate Markets: In hot real estate markets, the theory can be seen when investors purchase properties at high prices, expecting to sell them at an even higher price. This can work until the market cools or corrects, leaving some investors with properties valued less than the purchase price.
3. Cryptocurrency: The cryptocurrency market, known for its volatility and speculative nature, often sees instances of the Greater Fool theory in action. Investors may buy cryptocurrencies at high prices, hoping that their value will increase and that they can sell them to someone else for a profit.
4. Collectibles and Non-Fungible Tokens (NFTs): Markets for collectibles or NFTs can also exhibit characteristics of the Greater Fool theory. The value of these items can be highly subjective and driven by speculation, leading investors to purchase them with the hope of selling them to someone else who values them more highly.
5. Penny Stocks and Highly Speculative Investments: These are often targeted by investors hoping to quickly flip them for sizable profits. The liquidity and information asymmetry in these markets can sometimes allow for significant gains based on selling to those who are less informed or more optimistic about future prospects.
It’s crucial to understand that the greater fool theory inherently suggests a level of risk, as it relies on the assumption that there will always be someone else willing to pay a higher price. When the pool of willing buyers dries up, the last holders of the asset can encounter significant losses, as the asset’s price corrects to reflect its intrinsic value or market conditions change. Which brings us to…
What are the risks of the greater fool theory?
Perhaps the biggest risk of the greater fool theory is buying an asset for a foolish price, just before the asset’s price declines. Going back to the technology example above, it would be like buying a new smartphone for $1,000, only to see the same phone listed for $449.99 six months later.
Losing money is one risk, but so is buying assets without evaluating their true worth. Ignoring valuation metrics under the assumption that another investor will come along and buy the asset from you is a bit like foregoing the inspection on a used car: without at least examining the engine, you could buy a car with expensive problems. Unless you can also find a buyer who will forego the inspection, you could then be stuck with a lemon.
Should you use the greater fool theory to invest?
The greater fool theory is a risky short-term investing strategy, and it’s not the best way to build wealth over the long run.
For one, hype around stocks is never sustainable. At a certain point, the bubble will burst, and investors will wake up to a stock’s true value. You might get lucky and sell your overvalued stocks before this happens. But that’s not for you to decide. If you misread the market, or if investors begin demanding lower prices for a stock, you could become the greatest fool.
In many ways, the greater fool theory can be reduced to a game of duck-duck-goose, in which the investor who owns the asset last (before its price falls) is the greatest fool of all.
In the short term, popular sentiment might play a big role in pricing a stock. But over the long term, a stock’s true value will emerge: fundamental factors, such as cash flow, revenues, leadership, business model, liabilities, and earnings, will determine how a stock performs on the market. While you can make money as a greater fool investor in the short term, you’ll likely earn more over the long run if you pay attention to these fundamentals.