In order to choose securities to buy, usually, investors conduct a lot of research and do a lot of analysis and calculus to find the best options. But ‘best options’ don’t always mean the same thing for all investors.
Different theories and models try to suggest the best paradigms to follow by investors for higher profits and less risk, among those theories there is “The Greater Fool Theory”.
The greater fool theory is a type of speculative phenomenon that says people will buy something without considering its intrinsic worth, so long as another person (or fool) is willing to buy it for an even higher price.
The greater fool theory can be summed up in the following statement: “Yes! I know I’m a fool for buying this asset right now for such a high price, but I’m convinced I’ll find a greater fool to sell it to later on for more”. This means that it is possible to make money by buying overvalued securities and selling them for profit at a later date because there will always be someone (i.e., a greater fool) who is willing to pay a higher price.
So this theory relies on finding a person who holds an unrealistic view about the true value of something, then selling it to them at a high rate, and then they try to resell it to someone else for more than what they paid for it, and so on…
“It’s buying something because you expect the pool of people who want to buy it and sell it to somebody else will grow”Warren Buffett
The greater fool theory vs value investing:
Value investors recommend investing in assets that show strong earning potential and growth aptitude in the long term. They look at the asset itself and what it can produce because they believe that at the end of the period they don’t only have what they bought in the first place but also something that the asst produced.
On the other hand, the greater fool theory protagonists don’t take the intrinsic value of an asset into account, because all they rely on is whether the next person is going to pay more because they’re even more excited about another next person coming along, even if the asset itself is creating nothing.
The greater fool theory and cryptocurrency:
Nowadays, when we’re talking about the greater fool theory, the most concrete example we can cite is cryptocurrencies.
When a person buys a certain amount of crypto they are not looking for any intrinsic value or expecting it to produce anything over time. The reason why people buy crypto is that they believe that there are( and there will be) a lot of other people who are interested in buying that same amount for a much higher price.
The crypto world is growing so fast and more and more people are becoming interested in this field. People are also pushed by their “fear of missing out”, investing in cryptocurrencies is such a trend nowadays, and people don’t want to be left behind when it comes to trends, that’s why people are so excited about this field and are willing to pay tremendous amounts of money to buy crypto.
The greater fool theory and market bubble:
If people keep buying with this same irrational mindset, then this will lead to a cycle of higher prices that spiral out of control because buyers are solely focused on getting in before they’re left behind (i.e., finding their own fool), economists call this a ‘Market Bubble’.
A bubble occurs when investors pay more for an asset than may actually be justified, resulting in surging sky-high prices. It is an economic cycle characterized by the rapid escalation of market value, particularly in the price of assets. This fast inflation is followed by a quick decrease in value or a contraction also referred to as a “crash” or a “bubble burst.”
The greater fool theory, like any other theory, has its pros and cons. But, in general, we can say it’s a risky strategy to follow since it doesn’t rely on a deep analysis or mathematical methods, it’s more about luck. You can either get lucky in finding your greater fool or you can end up being the greater fool yourself.