What is the Greater Fool Theory?
The Theory states that there will always be a larger fool in the market willing to pay a higher price for an already overvalued security. Irrational thoughts and expectations from market players can significantly impact the market’s performance. The larger fool theory asserts that there will always be one investor, i.e., a “greater idiot,” who mistakenly pays a higher price for security than its intrinsic value.
Examples of the Greater Fool Theory in Action
The greater fool’s Theory of investing
It is possible to develop an investment strategy based on the notion that you can sell a security or asset at a higher price to “greater fools” who are willing to pay unreasonable multiples for an asset. Essentially, the Greater Fool Theory is that you can profit by betting on future price increases since there is always a larger fool prepared to pay more than you paid, even if you paid too much based on the inherent value of the investment. If a speculative bubble finally bursts and investors discover that the price of an investment is excessively high, greater fool investing rests on the premise that someone else will be stuck with an investment. Greater fool investment is all about avoiding becoming the greater idiot.
Rather than precisely establishing an investment’s true or inherent value, this theory of investing focuses on the likelihood that you may sell the investment to someone else for a better price than what you paid for.
It is essentially a Game Theory that speculates what other investors are ready to pay for a security. It is the polar opposite of focusing solely on an investment’s intrinsic value.
The Financial Crisis
In the long run, valuations predicated on inflated multiples will not be sustainable. This irrational valuation will lead to a crisis when the bubble bursts. Consider the subprime mortgage disaster, in which people borrowed money from banks to buy houses in the hopes of selling them to a richer idiot later on for a profit.
Those tactics worked for a long time because there always seemed to be more foolish people to dupe. However, when more and more people realized that “that house is not worth that much – it is overpriced,” the supply of fools began to dwindle. As a result, banks had to wipe a large amount of credit provided to these mortgage borrowers off their balance sheets because the sellers could not find buyers. Eventually, this resulted in the greatest economic downturn in decades due to the resulting nationwide financial emergency.
More than anything else, the larger fool idea aims to shed light on how speculative bubbles emerge, not to offer traders a way to locate idiots for their trading systems to exploit.
The latest Bitcoin craze
Bitcoins have periodically made news for the past few years, igniting heated disputes about their viability and value. The obvious inquiry is, why does the market so highly appreciate them?
Return on investment (ROI) is a common way to estimate an asset’s value. This is the equivalent of a dividend for stocks. However, the value of Bitcoin as an asset is nil because it will never generate dividends or returns. Alternative: It could be considered a commodity (like oil or gold) with intrinsic worth. Aside from its intrinsic value as a metal and a decorative item, gold’s value is elevated further by the fact that it is becoming increasingly difficult to get precious metal bars today. There is no intrinsic value in Bitcoin. In order for it to be worth anything, it would have to be zero.
Although we might use it as a means of payment, the true worth of currency is derived from the fact that it can be used to buy and sell things and services. Likewise, Bitcoin is useless as a medium of exchange because it cannot be utilized in this way.
This year’s predicted price for Bitcoin is a major factor in its current value. To make a profit, investors (also known as “bitcoin holders”) are betting that the price of bitcoin will rise. As a result, this is a classic example of the larger fool theory.
At this point, you probably think that this notion is too fantastic to be true. Why do we not see a steady stream of wealthy people benefiting from this Theory? Is not the hypothesis of the larger fool foolproof?
Asset prices must keep rising indefinitely if the principle of the greater fool holds true at all times. However, indeed, nothing lasts indefinitely—not even price increases.
How to Avoid Being a Greater Fool?
To be clear, nothing in the stock market can be predicted with 100 percent accuracy. There are no certainties in the market, which operates according to a constantly shifting set of trends. An asset’s price can rise or fall significantly depending on market conditions.
Diversification is essential. Before credibility and past performance, various securities and assets should be included in the portfolio.
Before investing, it is important to conduct a thorough study, planning, and market research. A well-thought-out plan must be devised and put into action. Stock market bubbles can be avoided by using a long-term investment strategy.
Just because other people are making an investment does not mean the general public should follow suit and pay more. Before deciding to invest, you must decide for yourself whether or not you are willing to put your money at risk.