Does The Greater Fool Theory Work in Investing?

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Overview

“You may be a fool to pay as much as you did, but you are betting that there’s a greater fool down the road. And if you are right, then, of course, you aren’t being foolish.”

The concept here is you are buying 100% on the belief you can sell it to someone for a higher price.

The Greater Fool Theory says that it is possible to make money by buying securities, whether or not they are overvalued, by selling them for a profit at a later date.

The thesis you can sell to someone else is the totality of your decision making. One of the examples is Bitcoins. In 2017, Bitcoins have appreciated from around $1000 to $20,000 in a span of fewer than 12 months.

The Greater Fool Theory

The Greater Fool Theory relies on timing and momentum, and it is possible to enjoy strong returns with this approach.

However, without analyzing fundamentals and market forces beyond near-term investor enthusiasm, it’s difficult to have a grasp on whether the timing of your purchases will be fruitful.

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When Does The Greater Fool Theory Work?

It works when you believe that “This time it is different”.

You shouldn’t be surprised if reducing excitement among investors for an asset or a shift toward a fundamentals-based valuation leaves you with depreciating assets.

Investors buying assets without any concern for fundamentals tend to create valuation bubbles. And that can mean big losses when the bubbles burst. 

How Does This Theory End?

The Greater Fool Theory ideology starts fuelling and causing the stock market bubble. Unfortunately, later, this always ends up with a speculative bubble burst and eventually leads to a rapid depreciation in the price due to the sell-off.

Nonetheless, there will always be someone who will be left stuck with the investment when the speculative bubble finally bursts.

But the theory failed in 2008 when investors purchased faulty mortgage-backed securities. Later, it was difficult to find buyers when the market collapsed.

How to Avoid Being a Greater Fool?

  1. Do not blindly follow the herd – Paying higher and higher prices for something without any good reason.
  2. Do your research and follow a plan.
  3. Adopt a long-term strategy for investments to avoid bubbles.
  4. Diversify your portfolio.
  5. Control your greed and resist the temptation to try to make big money within a short period of time.
  6. Understand that there is no sure thing in the market, not even continual price inflation.
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If you want to avoid being a greater fool, avoid purchasing a stock just because its price is increasing.

Another example, the Gold price per gram was around Rs. 3200 in 2019 and currently at around Rs. 5000.

When the gold market did a rally, greater fools chose to keep quiet. But then, suddenly, everyone started speaking about it when it moved to Rs. 8000. And thus started the buying spree in Gold or Sovereign Gold bond.

To deal with the Greater Fool theory in practice, you must focus on quality stocks where you can earn above-average returns in the long run.

Historically, the Greater Fool theory has always imploded with hugely negative consequences.

The best you can do is to avoid being the Greater Fool in the entire spiral!

Benjamin Graham once wrote that “in the short run, a market is a voting machine, but in the long run, it is a weighing machine.

Graham was conveying that popular sentiment plays the biggest role in shaping stock market pricing action in the short term, but fundamental factors determine how a company’s stock performs over longer periods.

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Adroit Financial

Adroit Financial

SEBI Registered PMS Advisor - INP000005349
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