The Greater fool theory is one of the most popular theories in the investing world. Many people follow this theory un-knowingly.
In this post, we are going discuss what is the greater fool theory and how it affects your investment decisions.
What is The Greater Fool Theory?
This theory states that it is possible to make profits by purchasing assets (which may be over-priced) and selling it to another person (a bigger or greater fool) who is willing to pay even a higher price for that asset.
The greater fool theory supports the principle that there will always be a ‘greater fool’ in the market who will be ready to pay a higher price based some ‘un-justified’ valuation for an already over-valued asset. The new estimate might be based on a higher irrational multiple for the asset.
Here, the investors purchase the assets without any regard to the fundamental quality or underlying principle but only with irrational beliefs and expectations. They hope to sell it off at a higher price to another investor (the greater fool), who might also be hoping to do the same with someone else in future. The price of the assets is determined by what the buyer is willing to pay, ignoring the true worth of the asset.
Overall, here the investors are happy to pay too much for an asset just because they believe that a greater fool will be willing to pay more in future.
Where this theory ends…
Have you ever played the game of ‘Musical Chair’?
In the musical chair game, X number of chairs are arranged in a circle and (X+1) people moving around the circle while the music is playing.
When you run around the chairs, you might be happy thinking that there are enough number of chairs and all you need is just one. However, everything changes when the music stops and you might not be able to find even a single chair. Here, the irrational expectation that there are enough fools (chairs) may led you to lose the game.
The Greater fool ideology starts fuelling and causing the stock market bubble. Unfortunately, later this always ends up with a speculative bubble burst and eventually leading to rapid depreciation in the price due to the sell-off.
Nonetheless, there will be someone who will be left stuck with the investment when the speculative bubble finally bursts.
This is because when the end approaches, people begin to realize that the price attached to the investment is just un-realistically high and hence, they might not be willing to pay a greater price for that asset. However, the ones who have already purchased that asset at a high price might be stuck with it.
The key point here is to make sure that the greater fool isn’t you.
DOT-COM Bubble burst was an example of how the greater fool theory ends.
The greater fool theory can help to explain how speculative bubbles are formed in different assets.
During the dot-com bubble, the prices of every IT companies were highly inflated. The theory supported buying of over-valued stocks in a hot market (IT Sector) with an expectation that a greater fool will come along and buy it from you at a higher rate.
At that time, instead of focusing on trying to find the true/intrinsic value of the companies, people followed the ‘herd-mentality’ to invest in any and all IT Companies. They were purchasing the stock and simply trying to find a greater fool whom they can sell the stock at a higher price than they themselves paid.
However, the end of the DOT COM Bubble was not so happy, and many of the investors who planned to sell their over-priced stocks later turned out themselves to be ‘the greater fool’.
How to avoid being a greater fool?
Now that you have understood this concept, it’s more important to avoid being the greater fool than just to know the theory.
Anyway, it’s quite simple to avoid being a greater fool. And here’s how you can do it- “Before making your investment in any assets, do your own study and research. Do not blindly follow the herd, paying higher and higher price without any reason.”
Many people invest in some stocks just because it’s stock price is going higher and increasing too fast. Although they know that the price of that stock cannot be stable at that inflated price, still they are willing to enter the stock with the expectation to exit soon enough making some profits.
If you want to avoid being a greater fool, avoid purchasing a stock just because its price is increasing. Control your greed to make money by irrationally buying over-priced stocks just with an intuition that you can sell it off later at even a higher price.
That’s all. Stay away from being a greater fool. And I hope this post is useful to you.
Please comment below what you think about ‘The greater fool theory’ and how relevant this theory is with the present stock market scenario.
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