The Greater Fool Theory

The "Greater Fool Theory" can be applied to any form of investing, whether it be investing in the real estate market, stock market or otherwise.

The "Greater Fool Theory" is when a person buys an asset not because they think that it is an attractive or undervalued; they are buying it in the hopes that someone else will pay more for it down the road. This is the "Greater Fool Theory".

The end of the first Internet boom was a perfect example of the "Greater Fool Theory" in full effect.

Most people knew that the companies that they were buying were complete garbage with no hope of ever making any money. They didn't care though. They would buy that piece of trash Internet company for $200 in the hopes of flipping it a day or two later for $250. The "Greater Fool Theory". Did they use some complicated analysis to ascertain that this was an undervalued and underappreciated stock? No way. They simply wanted to flip it to a "bigger" fool who was willing to pay more money for the stock.

Home buying in the United States over the past 4-5 years has been an exercise in the "Greater Fool Theory".

Did people really think that the house that they bought for $750k (which was sold for $300k three years ago) was a great long-term investment? In most cases, no. In many cases, people simply bought the home at $750k, banking on the fact that they would be able to "flip" it a year or two later for much more money.

"The Greater Fool Theory" is like musical chairs. When the music stops, someone always doesn't have a seat to sit in. With the "Greater Fool Theory", someone is always left holding the bag at the top. Someone always buys in at the exact top of the market. This goes hand in hand with the saying "Sheep get slaughtered". The herd is almost always wrong. If you truly want to make money over the long-term through investing, you need to develop somewhat of a contrarian attitude and not get sucked in to the magnetic pull of public opinion. Think for yourself.

Filed under: Stock Market Education | General Knowledge