The Greater Fool Theory

If you have ever purchased a stock, real estate or an item on Ebay for more than it was worth, you may be a victim of the Greater Fool Theory.  The Greater Fool Theory is based on the belief that even if you pay more than an item is worth, you can always sell it to someone else for even more.  The problem with this theory is that you may become the greatest fool and get stuck with the item at the highest price.

My inspiration for writing this post came from the many complaints I see on personal finance blogs about how real estate and the stock market are such poor investments.  And, as I read the details of these posts and comments, something became very obvious to me.  These people had bought near the top of the market and they paid way too much.  Whether they were victims of GFT or just had bad timing, I’m not sure.  But, I am sure they are misguided in their attempt to blame the asset.  They should be blaming themselves for paying too much.  It was probably a great investment for the previous owner, who sold it to them for top dollar.

The History of Foolishness

The Fools Festival in Belfast

Photo by Pawelbak

The Dutch “Tulip Mania” of the 1630s, was one of the first examples of the rise and collapse of a speculative bubble market.  Other historical examples are the stock market crash of 1929 or the silver crash of 1980.  More recent examples are the dot-com bubble of 2000 and the subprime mortgage crisis of 2008.

In all of these examples, the prices of these assets rose to unsustainable levels, based only on the belief they would keep going up.  But, there was no fundamental value to support those prices, only pure speculation.

History seems to repeat itself, because speculators are still on the lookout for the next hot thing.  And, they have already forgotten the hard lessons from the last crash.

Missing an Opportunity

I have a friend who likes to ask me for advice and then argue with me about my recommendations.  He’s pretty worldly.  And, I suspect he likes to debate more than he dislikes my advice.  He came to me in late 2008 and asked me if he should invest in the stock market, while it was down.  He had a large sum of money sitting in a bank account.  I told him that I thought it was a great time to invest.  But, I recommended he put in a couple thousand dollars per month, to average out any remaining volatility.

He never took my advice.  Instead, he left a lot of money sitting in the bank earning 1-2% interest.  I’m pretty sure he lost money on this investment, after taxes and inflation.  Meanwhile, the stock market rose dramatically and he completely missed out.  I don’t pretend to know where the market is headed, because nobody really knows.  The moral of this story is that money can be lost by indecision, just as it can from speculation.

Consider the Value

During the dot-com era, Warren Buffett was widely criticized for avoiding tech stocks.  Everyone thought he had lost his touch.  He was considered a dinosaur by many, who believed the old rules of business no longer applied.  Warren took this all in stride.  His simple explanation was that tech stocks were overvalued.  It didn’t matter to him how popular tech stocks were or that technology would change the world.  The net income from these companies didn’t justify their stock price.  So, he didn’t buy them.  After the tech bubble burst and fortunes were lost, the concept of value returned to prominence.

Unfortunately, the concept of value didn’t find its way into the real estate market.  Within a few short years, the old rules of housing didn’t seem to apply.  No one was concerned about paying a half million dollars for a tract home, as long as they could qualify for a loan.  And, bankers were more than happy to provide loans, as long as they could sell them off to investors.  This was the Greater Fool Theory in its most sophisticated form.  With the greatest fools being the taxpayers, who got stuck with the tab for a bailout.

Profit from Others

Here is the profit lesson from this post.  If you are still with me, I hope you find this information valuable.  Whenever a bubble pops or a crash occurs, the market seems to over-correct.  And, the price of the asset drops below its normal value.  Often, it drops far below its value.  And, this presents a great buying opportunity.  All you have to do is to watch the bubble pop and jump on the under-valued asset.  Finding the bottom can be risky.  But, you can spread out your purchases and wait until the market starts to recover.

In my particular case, I am usually inside of the bubble when it pops.  But, I have had great luck recovering my portfolio, by stepping up my purchases, after the market tanks.  Keeping your sanity is the hardest part of this strategy.  And, avoiding the natural impulse to sell and run for cover.  What helps me the most is to remember that I am an owner and not a speculator.

The Bottom Line

The bottom line is that bubbles happen.  And, they can be very profitable, as long as they don’t pop while you are invested in them.  See through the hype and never lose track of the value.  Because, the old rules may change from time-to-time, but value remains a constant.

“A wise man can learn more from a foolish question than a fool can learn from a wise answer.”

Bruce Lee – Legendary Actor and Martial Artist

Recommended Reading

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6 comments to The Greater Fool Theory

  • “A wise man can learn more from a foolish question than a fool can learn from a wise answer.”
    Because a fool does not learn from anyone!

    • Daddy Paul,

      That’s pretty much what I was trying to say with the quote. I was just trying to be subtle so as not to offend the foolish.

  • I like this article. Its good for all of us to remember to realize that assets that are priced beyond their underlying values are likely going to regress back at some point. Or, it may a case of financial musical chairs – when the music stops, you’re out of a seat (I think that was the game I played in school as a young kid!). You can’t get away from value.

    As you said, bubbles do happen, and have happened for generations. I like your point about being able to profit from bubbles, even in the downturns. Often times markets overreact, and one can take advantage of the opportunity. The bottom line is to keep a clear head think rationally and with long-term perspective – both prosepctively and retrospectively.

  • Hemp Fan

    I have seen first hand how people have bought property, not as a home, but as an investment, then try to flip it to someone after giving it a lick of paint and some cheap furniture from ikea. Also, i have experienced much social trauma from it, as people who are generally stupid, start to walk around with their noses in the air, thinking they were rich and powerful, quite the opposite, as we are about to see. condesending those that could see the blatant bubble that was developing. I have been vindicated now. I can’t get angry, as its human nature to be greedy, and i advise anyone who has sense to step back from the system and get out of the way, as there will be many people who cannot accept that they have been completely foolish, and will take it out on government, the dog, etc. Protect yourself.

    The problem is, there is nothing left to scam as the partys over, mainly due to decline in north sea revenues. I hope people enjoyed it, because it was the last hurrah for this country. Unless a new source of growth is found that doesn’t rely on debt, this place will look like zimbabwae, just not as hot.

    • @Hemp Fan,

      I have noticed a lot of that as well. People seem less industrious than just a few decades ago. No one wants to work hard to create anything, which is what made our nation great in the first place. Businesses either want to be the middle-man and snag an easy mark-up or they want to outsource and off-shore everything. Financial institutions want to gamble with derivatives or soak their customers with fees, instead of creating earnings from responsible lending. Workers want to sit in an office and collect a check. College students are unwilling to take the difficult math and science classes. Most of our Engineers and PHDs are either foreign-born or the children of immigrants.

      I’m not sure if we are getting soft or if we have just had it too good for too long. But, I do know our economy was founded on the backs of brilliant engineers, scientists and industrialists. And, even though we are transitioning to a knowledge-based economy, somebody has to create something in order for us to remain prosperous. We certainly cannot thrive in an economy based entirely on consumer spending.

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