The Concept of Greater Fool Theory: Soaring Heights with Risky Foundations
The Greater Fool Theory argues that prices escalate as investors can sell overpriced securities to a ‘greater fool,’ irrespective of their actual value—until no greater fools remain.
Disregarding Fundamentals: A Risky Endeavor
Investing under the Greater Fool Theory means many prioritize quick profits over valuations, earnings reports, and fundamental data. This can lead to severe financial losses once the market corrects itself, leaving investors ‘holding the bag.’
Key Takeaways
- The Greater Fool Theory suggests you can profit from overvalued securities since there’s typically another investor willing to pay even more.
- Market correction becomes inevitable when there are no more ‘fools’ left.
- Conducting due diligence is essential to avoid falling prey to this speculative behavior.
A Deeper Dive into the Greater Fool Theory
Investors following the Greater Fool Theory often purchase highly-priced securities without a proper assessment of their worth. The objective here is to quickly offload risky assets to another investor —a so-called ‘greater fool’—hoping to repeat the buy-sell cycle.
Many markets, inflating on bubbly speculations, face drastic declines after reaching unsustainable heights. Notably, the 2008 financial crisis saw mortgage-backed securities plummet, leading to widespread distress and loss.
In 2004, the U.S. homeownership peaked. By late 2005, home prices fell, triggering a 40% drop in the U.S. Home Construction Index by 2006. Subprime borrowers’ defaults caused even bigger institutions with nearly $1 trillion in liabilities to suffer profound distress.
Holding Ground with Intrinsic Valuation
The 2008 crisis magnified the risk of holding flawed, debt-laden securities. Proper due diligence, including thorough valuation models, is crucial in determining an investment’s true quality.
Comprehensive due diligence involves both qualitative and quantitative assessments, such as capitalizing a company’s value, trending earnings results, competitive research, industry context, and leveraging metric indicators like price-to-earnings (PE), price-to-sales (P/S), and price/earnings-to-growth (PEG) ratios.
Another form of due diligence extends to understanding management’s impact and ownership structures, ensuring informed and secure investment decisions.
Greater Fool Theory Example: The Bitcoin Craze
Bitcoin’s exponential price rise often serves as a textbook example of the Greater Fool Theory. Despite debates over its intrinsic value, massive energy consumption, and its virtual existence through computer-stored lines of code, Bitcoin experienced unprecedented price surges.
By the end of 2017, Bitcoin reached $20,000 only to correct itself soon after. Traders invested heavily, hoping to resell at higher margins, nourishing its swift price rise as demand outweighed supply.
2020-21 experienced Bitcoin transcending new price heights above $60,000, fueled partly by institutional interest from companies like Tesla and PayPal. Whether or not these can be generalized as ‘greater fools’ remain contested, hence challenging an absolute classification under the Greater Fool Theory.
Related Terms: overvaluation, valuation, corrective measures, due diligence, intrinsic value, speculative bubbles.
References
- Yahoo Finance. “Dow Jones U.S. Home Construction Index”.
- Statista. “Homeownership Rate in the United States from 1990 to 2020”.
- Coindesk. “Bitcoin”.
