Greater Fool Theory: What Is It, How to Spot It, and How to Avoid Being It.
As an investor, you’ll already be familiar with the concept of market bubbles and how in-demand assets can, in some instances, rise above and sell for more than their intrinsic value. While economic experts are still undecided as to how market bubbles form and continue to grow, one prevailing idea is the Greater Fool Theory.
What is the Greater Fool Theory?
According to the Greater Fool Theory, or the Bigger Fool Theory, someone can sell securities for a profit, regardless of whether they’re overvalued or not, because there will always be someone willing to pay more for them.
In short, you’re banking on someone being willing to buy your assets from you for more than you paid for them - oftentimes without any theory as to why they may be willing to do this.
However, most followers of the Greater Fool Theory believe that they’ll be able to sell their assets to someone also looking to flip them, someone caught up in a speculative bubble, or someone with their own reason for why they’re willing to pay more for that asset.
Greater Fool Theory in the Real World
Bitcoin is a great example of the Greater Fool Theory.
Bitcoin as an asset doesn’t have any intrinsic value, but that didn’t stop the value of a single Bitcoin from reaching $20,000 in 2017. Bitcoin purchasers often banked on the Greater Fool Theory in that there was always someone willing to buy their assets for more money, simply because blockchain technology in fintech was looking extremely promising.
When investors and Bitcoin traders saw the high price of Bitcoin in 2017, a flurry of buying and trading took place with the hope of cashing in vast profits from the increasing prices. However, this resulted in the burst of the Bitcoin speculative bubble at the start of 2018, which left traders at the time with assets that were worth significantly less than what they may have paid for them as the bubble grew.
While in 2021 the price of Bitcoin has skyrocketed again, leaving traders who held onto their Bitcoin from the 2017 bubble able to sell their Bitcoin for a profit, there’s current speculation that the Bitcoin bubble will burst yet again in the near future following a massive increase in price since March 2020.
Who Benefits from the Greater Fool Theory?
Fool’s Theory greatly relies on timing and momentum. So, the investors who will benefit most from Greater Fool Theory tend to be those who are skilled at anticipating the growth of valuation or speculative bubbles and purchase assets in those bubbles as prices begin to rise.
However, these investors must also be able to sell their assets before that bubble bursts so they’re not left with depreciating assets.
Because the Greater Fool Theory is a risky approach to short-term investments, the people that generally benefit from this approach are those with a diversified portfolio who are willing to hold onto devalued assets if their gamble doesn’t pay off. As with the multiple Bitcoin bubbles, it can eventually pay off to wait on these assets, but investors must be prepared to strategize in this way if they want to gamble on the Greater Fool Theory.
Who Loses Out from the Greater Fool Theory?
Long-term investors will always lose out from Greater Fool Theory, as this theory relies on investors taking advantage of short-term market bubbles to find the ‘Greater Fool’.
Also, because it’s not unheard of for prices and market trends to reverse in minutes, the losers of the Greater Fool Theory tend to be those who purchase hot assets without closely monitoring market conditions to find the best time to sell.
Finally, the ‘Greater Fool’ will always lose out from this theory, as they’ll be left with depreciating assets.
Retail Investors vs The Greater Fool Theory
The investing industry is comprised of many different types of investors, from hedge funds to accredited investors to insurance companies (collectively institutional investors) all the way down to retail investors at the very bottom of the investing food chain.
Retail/individual investors are thought to be less knowledgeable, less disciplined and less skillful than institutional investors (fewer sources available) so they are often presented with more risky investment opportunities.
Another fear for retail investors is that their naivety is preyed upon by larger brokerage firms who often tend to practise The Greater Fool Theory.
In this case, the greater fool tends to be the retail investors who don't know any better. Brokers can trick new/naive investors into buying stocks that the broker needs to sell, for a very high over-inflated price.
How to Avoid Being the ‘Greater Fool’
The best way to avoid being the ‘Greater Fool’ is to carefully evaluate the assets you want to purchase and the value that they hold.
Many investors fall for the Greater Fool Theory because of the promise of making a big profit in a short period of time, but because they don’t carefully evaluate the market bubble, they end up with depreciating assets.
So, you should remember to stick to your investment plan, avoid the temptation of hot stocks, and if you do want to play the Greater Fool game, remember to diversify your portfolio so any losses aren’t detrimental to your overall investment plan.