What Is the Greater Fool Theory?
Let me explain the greater fool theory to you directly: it argues that prices rise because people can sell overpriced securities to a 'greater fool,' regardless of whether they're actually overvalued. This works, of course, until there are no greater fools left to buy.
When you invest based on this theory, you're essentially ignoring valuations, earnings reports, and all other fundamental data. Dismissing these basics is risky, and if you follow this approach, you might end up holding the bag when the market corrects.
Key Takeaways
- The greater fool theory states that you can make money from buying overvalued securities because there will usually be someone (i.e., a greater fool) who is willing to pay an even higher price.
- Eventually, as the market runs out of fools left, prices will sell-off.
- Due diligence is recommended as a strategy to avoid becoming a greater fool yourself.
Understanding the Greater Fool Theory
If you act according to the greater fool theory, you'll purchase securities that are questionably priced without considering their quality. The idea is that you can quickly sell them to another 'greater fool' who also hopes to flip them fast.
Unfortunately, speculative bubbles do burst, causing share prices to depreciate rapidly. This theory also fails in situations like economic recessions and depressions. Take 2008, for instance: investors who bought faulty mortgage-backed securities (MBS) struggled to find buyers when the market collapsed.
By 2004, U.S. homeownership peaked at just under 70%. Then, in late 2005, home prices began falling, leading to a 40% decline in the U.S. Home Construction Index in 2006. Many subprime borrowers couldn't handle the high interest rates and defaulted on loans. Financial firms and hedge funds holding over $1 trillion in securities backed by these failing mortgages went into distress.
Greater Fool Theory and Intrinsic Valuation
One reason it was hard to find buyers for MBS during the 2008 crisis was that these securities were based on very poor-quality debt. In any investment scenario, you need to conduct thorough due diligence, sometimes including a valuation model, to figure out the fundamental worth.
Due diligence covers a lot: it includes calculating a company's capitalization or total value, spotting trends in revenue, profit, and margins, researching competitors and industry trends, and placing the investment in a broader market context by looking at multiples like price-to-earnings (PE), price-to-sales (P/S), and price/earnings-to-growth (PEG).
You should also understand management—their decision-making effects and methods—and company ownership through a capitalization table that shows who holds the majority shares and has the strongest voting power.
Example of the Greater Fool Theory
Bitcoin's price is often pointed to as an example of the greater fool theory. This cryptocurrency doesn't seem to have intrinsic value (though that's debated), it uses massive energy, and it's just lines of code in a network. Despite that, its price has skyrocketed over the years.
At the end of 2017, it hit a peak of $20,000 before dropping. Traders and investors, drawn by the chance to profit from price rises, bought and sold rapidly, with many observers saying they were buying just to resell at a higher price later. The greater fool theory drove Bitcoin's price up quickly as demand exceeded supply.
In 2020-21, Bitcoin reached new highs above $60,000 and stayed over $50,000 for weeks. This time, big institutional investors and companies like Tesla and PayPal got involved—and it's debatable if they count as fools. So, maybe Bitcoin isn't purely an example of the greater fool theory after all.
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