The Greater fool theory is a popular theory in the investing world that many people follow ‘unknowingly’, is speculative in nature, and should not be recommended to follow if investors want to avoid losses. In this post, we are going to discuss what is the greater fool theory, how it affects your investment decisions, and how to avoid being a greater fool. Keep Reading
What is The Greater Fool Theory?
Greater fool theory states that it is possible to make profits by purchasing assets (which may be over-priced) and selling them to another person (a bigger or greater fool) who is willing to pay even a higher price for that asset. The greater fool theory supports the principle that there will always be a ‘greater fool’ in the market who will be ready to pay a higher price based on some ‘unjustified valuation for an already over-valued asset. The new estimate might be based on a higher irrational multiple for the asset.
Here, the investors purchase the assets without any regard to the fundamental value or underlying principle but only with irrational beliefs and expectations. They hope to sell it off at a higher price to another investor (the greater fool), who might also be hoping to do the same with someone else in the future. The price of the assets is determined by what the buyer is willing to pay, ignoring the true worth of the asset.
Overall, here the investors are happy to pay too much for an asset just because they believe that a greater fool will be willing to pay more in the future.
Where does This Theory end?
Have you ever played the game of ‘Musical Chair’?
In the musical chair game, X number of chairs are arranged in a circle, and (X+1) people moving around the circle while the music is playing. When you run around the chairs, you might be happy thinking that there are enough chairs and all you need is just one. However, everything changes when the music stops and you might not be able to find even a single chair. Here, the irrational expectation that there are enough fools (chairs) may lead you to lose the game.
The Greater fool ideology in the stock market is also very dangerous. Many times, it starts fuelling and causing the stock market bubble. Unfortunately, later this always ends up with a speculative bubble burst and eventually leading to rapid depreciation in the price due to the sell-off.
Nonetheless, there will be someone who will be left stuck with the investment when the speculative bubble finally bursts. This is because when the end approaches, people begin to realize that the price attached to the investment is just un-realistically high and hence, they might not be willing to pay a greater price for that asset.
However, the ones who have already purchased that asset at a high price at the wrong time might be stuck with it. If you are following this strategy, the key point here is to make sure that the greater fool isn’t you.
Example of how the greater fool theory ends: DOT-COM Bubble Burst
The greater fool theory can help to explain how speculative bubbles are formed in different assets.
During the dot-com bubble between 1995 to 2000, the prices of every IT company were highly inflated. The theory supported buying over-valued stocks in a hot market (IT Sector) with an expectation that a greater fool will come along and buy it from you at a higher rate. At that time, instead of focusing on trying to find the true/intrinsic value of the companies, people followed the ‘Herd Mentality’ to invest in any and all IT Companies. They were purchasing the stock and simply trying to find a greater fool whom they can sell the stock at a higher price than they themselves paid.
However, the end of the DOTCOM Bubble was not so happy. So many companies went bankrupt and shareholders lost money. Many of the investors who planned to sell their hot IT stocks later at high prices, themselves turned out to be ‘The Greater Fool’.
Herding in IPO Subscription
Another example, where investors turn out to be greater fools is while applying for hot IPOs.
Here, instead of looking for value, the strategy is to enter a popular IPO company where everyone else is applying and sell its shares in the secondary market when prices are high. However, the problem occurs when the prices of these newly public shares don’t go high after listing and investors are stuck with their overprices stocks.
How to Avoid Being a Greater Fool?
Now that you have understood this concept, it’s more important to avoid being the greater fool than just to know the theory.
It’s quite simple to avoid being a greater fool. Here’s how you can do it. Before making your investment in any assets, do your own study and research. Do not blindly follow the herd, paying the higher and higher prices without any reason.
Many people invest in hot stocks just because its stock price is going higher and increasing too fast. Although they know that the price of that stock cannot be stable at that inflated price, still they are willing to enter the stock with the expectation to exit soon enough making some profits.
If you want to avoid being a greater fool, avoid purchasing a stock just because its price is increasing. Control your greed to make money by irrationally buying over-priced stocks just with an intuition that you can sell it off later at even a higher price.
That’s all for this post. I hope this post is useful to you. Stay away from being a greater fool. Further, please comment below what you think about ‘The greater fool theory’ and how relevant this theory is with the present stock market scenario. Have a great day and happy investing.