Once upon a time, a farmer was allured by his neighbor about a magical land where crops grew overnight, and the harvest was bountiful. So he invested all his savings into the land without any due diligence.
But later, he discovered that the land was barren and nothing was growing. He realized he had been tricked by his neighbor, who sold him that land at an inflated price. The moral of the story is that one must be vigilant and research before making investment decisions to avoid becoming a ‘greater fool.’
In fact, an entire concept called “The Greater Fool Theory” in finance explains why people indulge in such activities.
What Is the Greater Fool Theory?
The greater fool theory states that someone will always be willing to pay more for an overvalued security. It means that an asset’s value is determined by the demand of a specific consumer rather than its inherent worth. As a result, even purchasing an overvalued security can lead to future profits, as it can be sold to another person (aka a greater fool) at an even higher price.
An investor who adheres to this theory will buy overvalued stocks or assets without regarding their true value. The theory is often associated with market bubbles. A market bubble is when prices of specific assets soar beyond their actual worth, as a section of buyers is willing to pay higher prices.
From a stock market perspective, the theory says you can make money by betting on a stock’s future price going up. But it’s risky because if the bubble bursts, you might be stuck with a stock that’s lost a lot of value. Thus, the key is knowing when to get out before the bubble pops. If you don’t, you could become the “greater fool” who loses money.
This also applies to other assets like cryptos, real estate, collectibles, etc.
Examples Associated With the Greater Fool Theory
Below are some examples of the Greater Fool Theory.
1. Dot-com bubble
During the dot-com bubble of the late 1990s, internet stocks were highly valued despite lacking solid fundamentals. Investors were buying these stocks with the hope that they could sell them to a greater fool at a higher price.
2. Housing market bubble
During the housing market bubble of the early 2000s, housing prices skyrocketed. Investors were buying properties with the expectation of selling them at a higher price in the future. But the prices were not supported by the underlying value of the properties.
3. IPO craze
The IPO craze is another typical example of the Greater Fool Theory. Investors buy shares of hot companies without doing proper research. The strategy is to buy shares of popular IPOs to sell them at a higher price in the secondary market. But the problem is that these investors are stuck with overpriced shares when the prices don’t go up after the listing.
It’s clear from the above examples that there’s no guarantee that you’ll find someone willing to buy the stock at a higher price.
Also, the theory is not meant to be used as a trading strategy that relies on finding other investors to buy at a higher price. It is just to help explain the phenomenon of speculative bubbles.
Crypto and Greater Fool Theory
There is a connection between cryptocurrency and the greater fool theory.
The value of certain crypto assets, like meme coins, is based on the perception of their worth. Their value can be highly inflated, not reflective of their actual value. This is similar to what happens in speculative bubbles.
But, it’s important to note that not all crypto investments are linked to the Greater Fool Theory. For example, Bitcoin, the first and most well-known crypto, has been gaining more mainstream acceptance as a store of value and a digital alternative to gold. Also, Ethereum is being used as a platform for building decentralized applications (dApps) and smart contracts.
Also, many other crypto projects focus on solving real-world problems and improving various industries. Thus, when investing in crypto, it’s essential to conduct thorough research to understand its underlying value and the technology behind it.
How to Avoid Being a Greater Fool?
Below are the practical steps to avoid becoming a greater fool.
1. Financial markets are unpredictable
One should understand that financial markets are a wild ride. This is especially true for volatile assets like stocks and cryptos. You never know which way they will go. Just because something is in a bull run doesn’t mean it will be tomorrow. It’s all about being ready for the twists and turns.
2. Diversify your portfolio
Don’t put all your eggs in one basket. Spread your investments around and choose a mix of different assets with good track records.
3. Have a long-term mindset
Before investing, one should conduct thorough research and analysis of the financial market and stick with it for the long haul. Avoid trying to make a quick profit by jumping on the latest trend.
4. Don’t blindly follow the crowd
Kindly avoid herd mentality. Don’t just follow the crowd and invest in something because others are doing it. Make your own decisions, and don’t let greed cloud your judgment.
Conclusion
The Greater Fool Theory is a reminder that greed and the allure of quick profits can lead to dangerous speculation and bubbles in the investing world.
It’s important to remember that true success in investing is built on a foundation of due diligence, research, and a long-term perspective.
Rather than trying to make a quick profit by buying into the hype of an overvalued asset, investors should focus on identifying and investing in assets with strong fundamentals. By doing so, they can avoid becoming a “greater fool” and instead find sustainable and profitable opportunities in the market.
FAQs
1. How can you be sure you are not the greater fool?
To avoid becoming the greater fool, investors should take a few steps:
- Conduct thorough research and due diligence
- Avoid following the crowd
- Have a long-term perspective
- Diversify your portfolio
- Be aware of market trends
By following these steps, investors can ensure they are not becoming the “greater fool” by buying into overvalued assets or securities.
2. What is the most important aspect of the greater fool theory of investing?
The Greater Fool Theory highlights the dangers of buying into overvalued assets or securities based on the expectation of finding someone willing to pay an even higher price.
The theory serves as a reminder that investors should avoid making hasty investment decisions and focus on understanding the fundamentals of the asset or security before investing.
Also, having a long-term investment perspective, diversifying your portfolio, and being aware of market trends is essential.
