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 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
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