What is the Greater Fool Theory?
Greater fool theory states that there will always be a greater fool who is willing to pay a higher price for an already overvalued security that may be due to his need or at the time of inflation. It implies that the price of any object is determined by the local and relative demand of a specific consumer and not by its intrinsic value and even buying an overvalued security will yield profits in future by selling to another person (greater fool).
Examples of Greater Fool Theory
The speculative bubbles, when formed by using irrational valuations instead of looking at the intrinsic valueIntrinsic ValueIntrinsic value is defined as the net present value of all future free cash flows to equity (FCFE) generated by a company over the course of its existence. It reflects the true value of the company that underlies the stock, i.e. the amount of money that might be received if the company and all of its assets were sold today. of the investment, are bound to burst and lead to a crisis. For example, the financial crisis of 2008, where people took loans from the banks to buy houses in the hope of selling these houses at a higher price in the future to make substantial gains. It worked for years until the supply of fools. That eventually someday began to dry up. As more people began to see the intrinsic value of the asset and suddenly, the mortgage takers could not find buyers that lead to banks writing up a huge amount of credit granted to these buyers off their balance sheet. This event leads to the banking emergency and eventually in the financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors..
In the stock marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price., this theory applies too, when many investors invest in a not so profitable company with an assumption that it will be sold later at a higher profit to a greater fool. Investment in any stock is not made by looking at its intrinsic value and its potential to provide higher returns; rather, it is made on assumptions that someone else is there to buy it at a higher price. It is called survivor investing.
Bitcoin and Greater Fool Theory
Bitcoin was a greater fool investment. It is a pure example of a greater fool theory type of investment where you are not producing anything but only expecting it to go up depending on the investment made by others. Bitcoin works on the same principle of greater fool theory, which suggests the cycle will continue with hopes of getting a higher buy price. Bitcoin be shorted by using future contracts on the world’s leading derivatives marketplace. Bitcoin works on the Ethereum blockchain system. These are cryptocurrencies that are of the gold standardGold StandardThe gold standard was a monetary term used when gold exchange was used instead of paper currency.. People who buy bitcoin expect other people to buy it from them at a relatively higher price, but the reality is that bitcoins are the deflationary coins or currencies that people hold for the long term. Bitcoin should not be looked at as a financial tool because it is blockchain technology. In a nutshell, bitcoins are non-productive assets that entirely work on the mercy of others to buy and raise their price.
Greater Fool Theory Investing
Greater fool theory is used to design an investing strategy which is based on the belief that a person will always be able to sell an asset or security at a higher price as compared to purchase price to a greater fool who is willing to pay a higher price based on unjustified multiples of security instead of looking at its intrinsic value. The whole idea is that money can be made by speculating the increase in future price irrespective of market conditions. This theory works based on the assumptions that there is not a single fool in the market but many. This approach of investing determines the likelihood that an investment of one individual can be sold to others at a higher price than what one has paid. This investing mechanism focuses on the formation of speculative bubbles, which may burst someday and lead to the crisis. It does not always promise to give higher returns and may even prove fatal for the investors as it does not works on the intrinsic value of an asset and its prospects to earn a higher yield in the future.
How to Avoid Being a Greater Fool?
- One should understand that there is nothing predictable, with 100% accuracy in the securities market. The market works on the order of diverse trends, and there is nothing certain in the market. The price of an asset that is higher today may either get inflated in the future or may decrease drastically based on the market conditions.
- The portfolio must be diversified. Various securities and assets must be included in the portfolio based on its past performance and credibility.
- Thorough research, planning, and market analysis should be made before investing. A proper strategy must be developed and implemented. A long-term strategy must be adopted for investments to avoid speculative bubbles.
- The common herd should not be followed by paying higher prices for something without any good reason just because others are investing. The self-decision must be taken before investing, and greed and temptation to make big money in a short period of time must be eliminated.
Greater fool theory is an investment mechanism that makes an investor purchase overvalued security without any regard to its quality, making it a greater fool that leads in the formation of speculative bubbles. To avoid becoming a greater fool, due diligence must be followed as a strategy, and always an intrinsic value of an asset or security must be evaluated for investment considerations.
This article has been a guide to what is Greater Fool Theory. Here we discuss how this theory works along with examples of bitcoin and explanation. You may learn more about finance from the following articles –