The greater fool theory of finance says it’s sometimes possible to make money by purchasing overvalued assets (items whose purchase price exceeds their intrinsic value) and reselling them for a higher price later.
This theory states that prices go up when people can sell overvalued securities to the “greater fool,” regardless of whether the securities are overvalued. Suppose one “fool” purchased an overpriced asset, hoping that he could sell it to an even “greater fool” who would profit from it. A system like this can only work if new “greater fools” are willing to purchase the asset at ever-higher prices.
Eventually, the market realizes that the price is too high, resulting in a significant drop in price until it reaches its fair value, sometimes even zero.
Understanding the Greater Fool Theory
A consumer acting based on the greater fool theory will often purchase questionably priced securities. The investor can still easily resell the assets to another “greater fool,” who may also try to sell them quickly.
However, bubbles eventually burst, leading to a rapid depreciation in the value of stocks. Likewise, the greater fool theory breaks down in other economic circumstances, including when the economy is in recession or depression. For instance, when the market collapsed in 2008, investors who purchased faulty mortgage-backed securities (MBS) found it difficult to sell them. Moreover, companies with assets worth over $1 trillion in securities backed by these failing mortgages also went into distress.
Intrinsic value and The Greater Fool Theory
MBS were difficult to acquire during the 2008 financial crisis because the debt used for the securities was of poor quality. Therefore, any time you invest, you should perform thorough due diligence, including a valuation model if necessary, to determine its value.
The due diligence involves a variety of quantitative and qualitative analyses. It may include calculating a company’s value; analyzing profit, revenue, and margin trends; evaluating competitors, and placing the investment in a market context — calculating certain multiples.
Additionally, investors should be knowledgeable about management and the ownership of the business.
Bitcoin as an Example
A common example of the greater fool theory is Bitcoin’s price. A cryptocurrency appears to possess no intrinsic value, consumes an enormous amount of energy, and consists of nothing more than lines of code stored on the internet. In spite of such concerns, the price of bitcoin has risen dramatically over the years.
This cryptocurrency peaked at $20,000 in late 2017 before retreating. Trading and investors eager to profit from its price appreciation quickly bought and sold the cryptocurrency. Some said they merely bought it to resell to someone else at a higher price later on. During a short period of time, the greater fool theory boosted the price of bitcoin as demand outpaced supply.
Can you tell if a client is trying to play this game?
Investors who are the greater fools are often impatient and draw attention to popular or “hot” stocks. Value stocks or consistent returns are far less important to them. In times of twitching markets, these clients will probably want to transfer their money to the next “hot” stock.
On the other hand…
I first heard of the greater fool theory while watching the TV show “The Newsroom” (which I highly recommend by the way). In one episode, the main character has a crisis of confidence. While he was ailing and feeling he was the fool, the economist in the newsroom team gives him a pep talk that ends with this gem:
Most people spend their life trying not to be the greater fool; we toss him the hot potato, we dive for his seat when the music stops. The greater fool is someone with the perfect blend of self-delusion and ego to think that he can succeed where others have failed. This whole country was made by greater fools.
… and for a second she made me want to be the greater fool.
Who wants to be this other kind of fool?
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