Greater Fool Theory

What Is the Greater Fool Theory?

The greater fool theory argues that prices go up because people are able to sell overpriced securities to a "greater fool," whether they are overvalued. That is, of course, until there could be no greater fools left.

Investing, as indicated by the greater fool theory, means disregarding valuations, earnings reports, and the wide range of various data. Overlooking the fundamentals is, of course, risky; thus people subscribing to the greater fool theory could be left holding the bag after a correction.

Understanding the Greater Fool Theory

Assuming that acting as per the greater fool theory, an investor will purchase questionably priced securities with next to no respect to their quality. Assuming that the theory holds, the investor can still rapidly sell them off to another "greater fool," who could also be hoping to flip them rapidly.

Sadly, speculative bubbles burst eventually, leading to a rapid depreciation in share prices. The greater fool theory breaks down in different circumstances, as well, including during economic recessions and depressions. In [2008](/extraordinary recession), when investors purchased broken mortgage-backed securities (MBS), finding buyers when the market collapsed was troublesome.

By 2004, U.S. homeownership had peaked at just under 70%. Then, in late 2005, home prices started to fall, leading to a 40% decline in the U.S. Home Construction Index in 2006. Numerous subprime borrowers were at this point not able to withstand high interest rates and started to default on their loans. Financial firms and hedge funds that owned in excess of $1 trillion in securities backed by these faltering subprime mortgages also started to move into distress.

Greater Fool Theory and Intrinsic Valuation

One reason that it was challenging to track down buyers for MBS during the 2008 financial crisis was that these securities were based on debt that was of exceptionally poor quality. It is important in any situation to conduct careful due diligence on an investment, including a valuation model in some circumstances, to determine its fundamental worth.

Due diligence is a broad term that encompasses a scope of qualitative and quantitative analyses. Some aspects of due diligence can incorporate computing a company's capitalization or total value; recognizing revenue, profit, and margin trends; researching competitors and industry trends; as well as putting the investment in a broader market setting — crunching certain multiples such as price-to-earnings (PE), price-to-sales (P/S), and price/earnings-to-growth (PEG).

Investors can also do whatever it takes to understand management (the effects and methods of their decision-production) and company ownership (through a capitalization table that breaks down who owns the majority of company shares and has the strongest voting power).

Example of the Greater Fool Theory

Bitcoin's price is in many cases refered to as an example of the greater fool theory. The cryptocurrency doesn't appear to have intrinsic value (albeit this is an area of discussion), consumes massive amounts of energy, and consists simply of lines of code stored in a computer network. Despite these concerns, the price of bitcoin has skyrocketed throughout the long term.

Toward the finish of 2017, it touched a peak of $20,000 before withdrawing. Drawn to the bait of profiting from its price appreciation, traders and investors rapidly bought and sold the cryptocurrency, with many market observers positing that they were buying simply because they hoped to resell at a higher price to someone else later. The greater fool theory helped the price of bitcoin zoom upwards in a short period of time as demand outstripped supply of the cryptocurrency.

The years 2020-21 saw Bitcoin rise to new highs, topping $60,000 and drifting above $50,000 for a really long time. This time, nonetheless, large institutional investors and corporations such as Tesla and PayPal have been engaged with the buying — and it is debatable whether they can be considered fools. So, perhaps Bitcoin is not an example of the greater fool theory, all things considered.

Highlights

• Due diligence is prescribed as a strategy to try not to turn into a greater fool yourself.
• Eventually, as the market runs out of fools left, prices will sell-off.
• The greater fool theory states that you can bring in money from buying overvalued securities because there will usually be someone (for example a greater fool) who will pay an even higher price.