By now, I’m sure you’re wondering if there’s anything else like the greater fool theory. Take some time to read over the following and see how it works. What is the Greater Fool Theory? Intrinsic Value And The Greater Fool Theory. Greater Fool Theory: Examples. The Psychology of Crowds. Dodging From Being A Greater Fool.
The Meaning Of Greater Fool Theory
The greater fool argument was initially stated by Professor Burton Malkiel. He claims that as an investor, you may buy stocks or other financial assets that are clearly overpriced and still earn. This stemmed from his discovery that people are frequently enticed to buy items whose prices have risen due to inefficiencies in human nature. He went on to say that the impact is exacerbated by herd instinct. Today’s successful people inspire others to pursue significant rewards. In other words, the idea goes, you can always sell the goods to a “greater fool.”
An illustration Of The Greater Fool Theory
If we understand the theoretical model of the crypto-asset market, it allows us to observe the creation of meme currencies. Doge and Shiba Inu are two of the most popular meme currencies. We are now extremely wealthy as a result of their presence. We can see the emergence of meme currencies by studying the theoretical underpinnings of the crypto asset market. The most popular meme coins are Doge and Shiba Inu. We are tremendously wealthy because of their presence. As more examples of people becoming billionaires become public, “bigger fools” assume they, too, can become millionaires. In other cases, meme coins, such as the “Squid Game” coin based on the popular South Korean Netflix show, are obvious forgeries.
Greater Fool Theory
Based on the greater fool theory, prices rise because people can sell expensive securities to a “greater idiot” regardless of whether they are overrated. That is, until there are no more fools to be found.
According to the greater fool theory, investing entails ignoring values, earnings reports, and all other information. Ignoring the basics is perilous. Meanwhile, those who believe in the larger fool notion may find themselves carrying the bag after a downturn.
- As the greater fool theory says, you can profit by buying overpriced securities since someone will typically be prepared to pay an even higher cost.
- Prices will likely fall as the business as the number of fools simmers.
- Thorough caution is suggested as a tactic for avoiding becoming a bigger idiot.
General Concept Of Greater Fool Theory
If an investor follows the greater fool hypothesis, he or she will buy controversial securities no matter how much they are worth. If the theory holds true, the investor will be able to swiftly sell them to another bigger fool. That can be a fool who may also be looking to make a rapid profit.
The greater fool theory fails in other situations, too, such as during economic downturns. When the market crashed in 2008, it was difficult for businesses to find buyers for bad mortgage-backed securities.
House ownership in the United States peaked at a little under 70% in 2004. Home values began to collapse, resulting in a 40% drop in the US Home Construction Index in 2006. Many borrowers could no longer afford the huge interest rates and defaulted on their loans. The subprime mortgage supporting the financial institutions holding up to or above $1 trillion in assets began to have problems as well.
Intrinsic Value And The Greater Fool Theory
During the 2008 financial crisis, one of the factors it was hard to find purchasers for MBS was that these assets were based on low-quality debt. To evaluate an investment’s intrinsic worth, it is critical to undertake complete due diligence on it, which may include using a valuation model in some cases.
Due diligence refers to a variety of descriptive and analytical evaluations. It matters when calculating a company’s market capitalization or total value; recognizing income, financial gains, and margin trends; conducting research on competitors and industry changes; and placing the investment in a wider market context—crunching certain multiples like price-to-earnings (PE), price-to-sales (P/S), and price/earnings-to-growth (PEG).
Customers can also learn about management (the consequences and techniques of their decision-making) and corporate ownership.
Variety Of the Greater Fool Theory
The price of Bitcoin is frequently used as an example of the greater fool theory. The cryptocurrency appears to have no intrinsic value. It uses a lot of energy and is made up of nothing more than lines of code stored on a computer network. Despite these worries, the value of bitcoin has risen dramatically over time.
It reached a high of $20,000 at the end of 2017 before falling. Interested traders and investors quickly bought and sold in order to make a profit from the price increase. Market observers speculated bitcoin was sold because the seller anticipated reselling it to someone else at a higher price later. Based on the greater fool argument, Bitcoin’s price soared in a short amount of time.
Bitcoin hit record highs in the years 2020-21, hitting $60,000 and hovering around $50,000 for weeks. Large institutional investors and organizations like Tesla and PayPal have been involved in the purchase this time, and whether or not they can be branded fools is debatable. After all, Bitcoin may not be an illustration of the greater fool theory.
There is ample proof that there are greater fools among investors.
The term “market bubble” is well-known to most people. Indeed, investors have witnessed two historically major market bubbles in the last two decades: the real estate market bubble in the 2000s and the tech-stock bubble in the late 1990s.
A market bubble, in technical terms, is an economic event in which the values of individual assets rise dramatically and exceed their intrinsic value. Bubbles are seen to be outbursts of irrationality, self-generating and self-sustaining waves of optimism that drive up asset values and misallocate assets. There is no universal agreement among financial scholars or practitioners as to what causes an asset bubble to arise or what keeps overvalued prices stable over time. The “Greater Fool Idea,” on the other hand, is a widely discussed theory about a bubble’s persistence.
The Greater Fool Theory states that during a market bubble, one might profit by purchasing inflated assets and later selling them again because someone would always be willing to pay a greater price. The Greater Fool Theory states that an investor will buy possibly overvalued assets regardless of their underlying value. This speculating method is based on the assumption that you can profit by betting on potential asset values and that you will always be able to find a “bigger fool” prepared to pay more than you did. However, when the bubble bursts (which it always does), there is a massive sell-off, causing asset values to plummet quickly. If you are the last person holding the asset and you cannot find a buyer during the sell-off, you could lose a lot of money.
The Greater Fool Theory comes into play in the stock market when the price of a stock rises to the point that it is being driven by the expectation that buyers will always be found, rather than the company’s intrinsic worth (cash flows). Any price (no matter how high) can be justified under this assumption. This is because another buyer is likely willing to pay an even greater amount.
Should you ever try to use a larger fool technique as a financial professional? How can you tell if a client is playing the greater fool game? What should you do if a client wants to acquire a stock that is overvalued?
Is it Ever A Good Idea To Try A Greater Fool Strategy?
There is plenty of evidence that larger fools exist in the world of investing. However, this is a high-risk approach that should not be used by long-term investors. Implementing a larger fool technique successfully takes a lot of time and effort. Markets require a lot of attention because price patterns can change in a couple of moments. The majority of clients (and financial advisors) do not have the time or resources to do so. For investors who do not have the speculative and market trend experience of full-time day traders, the greater fool method is typically not practicable or sustainable.
Furthermore, although guessing based on the Greater Fool Theory has the ability to profit, there is a high chance that your client (s) will be the greater fool.
You don’t want your client to be left standing when the bubble explodes and the music stops.
Knowing When A User Is Playing The Greater Cool Game
Greater fools are usually eager traders who are drawn to famous or “hot” stocks. They aren’t interested in value stocks or stable, consistent returns. These consumers will want to move on to the next “hot” stock as markets start to jitter.
What To Do When A Client Wants To Acquire A Stock That Is overvalued
Academics and finance experts have long known that stock returns are “mean-reverting” (that is, stock prices fluctuate but eventually return to their mean/average price). The price of a “hot” stock will eventually fall if it rises too much above its average. In these cases, it’s a good idea to inform your customer that no one has a crystal ball and can anticipate when a market bubble will burst or when stock will mean-revert. Tell them that a greater fool strategy is speculative and that they don’t want to be left holding the bag when there are no greater fools to sell to at a higher cost.
Extra Information About The Greater Fool Theory
The greater fool idea implies that buying overvalued assets—products with a purchase price that is significantly higher than their inherent value—can sometimes make money if those assets can later be resold for a higher cost.
Here, one “fool” might pay too much for an asset in the hopes of selling it to a “bigger idiot” and profiting. This works only if there are enough fresh “greater fools” prepared to pay ever-increasing prices for the item. When investors can no longer ignore that the price is out of touch with reality, a sell-off might occur, causing the price to plummet until it is closer to its fair worth, which in certain situations may be zero.
The Psychology Of Crowds
Some people are driven to assets whose prices they see increasing due to biases in human behavior, however irrational that may be. This impact is frequently amplified by herd mentality, in which people hear stories of others who bought in early and profited handsomely, driving those who did not buy to dread losing.
In periods of high inflation and in distant areas, the cost of needs might be so high that they appear arbitrary in comparison to normal markets. However, the local cost of conducting business in comparison to the price in these places, as well as the need to feed and shelter oneself in a hyperinflationary crisis, justify the “foolish” pricing through profit or actual advantage.
The greater fool principle might motivate real estate investment by assuming that prices will constantly grow. Lenders may underestimate the danger of default during a period of rising prices.
The greater fool idea applies in the stock market when a group of investors makes a risky purchase with the expectation of subsequently selling it to “a greater idiot.” In other words, they acquire something not because they believe it is worth the price, but because they hope they will be able to resell it for a higher price to someone else. Survivor investing is another name for it. The Keynesian beauty contest principle of stock investing is similar in concept.
More Specimens In Details
Artwork are another item where curiosity and special access influence prices instead of inherent value. Steven A. Cohen of SAC Capital, a hedge fund manager, was selling artworks he had recently acquired through private negotiations at auction in November 2013. On display were Gerhard Richter and Rudolf Stingel paintings, as well as a sculpture by Cy Twombly. At auction, they were expected to garner up to $80 million. The New York Times said of the sale, “Ever the trader, Mr. Cohen is also taking advantage of today’s frantic art market, where new collectors will frequently pay significantly more for artworks than they are worth.”
Digital currencies have been labeled as manifestations of the bigger fool theory. Cryptocurrency has been described as having no intrinsic value by a number of economists, including numerous Nobel laureates.
Trading According To The Greater Fool Theory
The greater fool idea can be used to create an investing strategy founded on the notion that you will always be able to sell a property or asset for a higher price to a “greater idiot” who will pay the price based on inappropriate multiples. Essentially, the theory is that you can profit by betting on future price increases since there will always be a larger fool prepared to pay more than you did, even if you paid too much based on the investment’s intrinsic value.
When the speculative bubble ultimately busts and individuals realize the price associated with investment is merely unrealistically high, greater fool investing assumes that someone else will be stuck with it. Making sure you’re not the larger idiot is the key to successful greater fool investing.
Instead of focusing on determining the true, or intrinsic, value of an investment, the greater fool theory approach to investing focuses on determining the possibility that you can sell the investment to someone else for a higher price than you bought.
The greater fool theory in investing is essentially a form of Game Theory that predicts what other investors will be prepared to pay for a security. It’s the polar opposite of focusing solely on an investment’s inherent value.
Take The Financial Meltdown As An Instance Of The Greater Fool Theory.
Market values based on exorbitant multiples are unworkable. These unjustified valuations will eventually burst the bubbles, culminating in a disaster. Consider the subprime mortgage crisis, in which people borrowed money from banks to buy properties with the intention of later selling them to a bigger moron for a bigger profit.
This succeeded for many years because there seemed to be an endless supply of bigger fools. The supply of fools began to shrink as more individuals understood that “that house isn’t worth that much – it’s overpriced.” Eventually, the sellers, or mortgage takers, were unable to find buyers, and the banks were compelled to write down a significant portion of the credit extended to these mortgage takers. This contributed to a national banking crisis, which led to the greatest downturn in years.
The goal of the greater fool theory is to help explain how speculative bubbles form rather than to financial economy a trading strategy based on identifying fools. The goal of the greater fool theory is to help explain how speculative bubbles form rather than to financial economy a trading strategy based on identifying fools.
Ways To Prevent Being A Greater Fool
- Do not mindlessly follow the crowd, paying ever-increasing prices for something that has no justification.
- Create a plan and do your homework.
- To prevent bubbles, stick to a long-term investment approach.
- Increase your investment strategy.
- Curb your selfishness and avoid the need to make a lot of money in a short amount of time.
- Realize that nothing in the market is guaranteed, not even rising prices.
The Use Of Greater Fool Theory
The greater fool idea is typically used as a quick investment strategy. Ultimately, you’re wagering that someone else will come along and buy your assets for a higher price than you paid, with no reason as to why.
This mindset is based on the assumption that someone else will be caught up in market momentum or will have their own fundamental argument for why the item is valued more than you spent.
The greater fool theory is used when someone buys bitcoin without considering its use cases, adoption, or underlying technology, only anticipating that someone else will buy it later at a higher price. Depending on when this investor buys and sells, they could make a lot of money or lose a lot of money.
Further On The Use Of The Greater Fool Theory
Another illustration of the greater fool theory’s risk-reward dynamics is the prosperity of the US property market over the preceding several decades. Based on the Federal Reserve, average inflation-adjusted house prices in the United States more than tripled. Homebuyers who used the greater fool theory were likely to profit if they bought and sold at virtually any point during that time period. There were no repercussions for failing to devote sufficient time and effort to learning the fundamentals and complexity of the real estate market.
If U.S. house buyers had bought in early 2007 with the belief that the real estate market’s outstanding speed would continue unabated, their property value would have likely plummeted. Housing prices continued to fall that year, eventually reaching a bottom in 2011 before beginning to rise again. The average home price in the United States did not reach its 2007 high until 2013. A “greater fool” may have ultimately appeared, but it took an average of six years for one to appear, and many real estate speculators were forced to sell their houses at a large loss before one arrived.
Merits And Demerits Of Using The Greater Fool Theory
The greater fool theory is built on velocity and speed, and this method has the potential to make a lot of money. However, without considering factors and market dynamics beyond short-term investor enthusiasm, it’s difficult to determine if the timing of your trades will be lucrative.
Don’t be surprised if the value of an asset falls owing to fading investor interest or a change toward a fundamentals-based assessment. When investors buy assets without considering the fundamentals, valuation bubbles emerge, which can result in huge losses.
“A market is a voting mechanism in the short run, but a weighing machine in the long run,” wrote legendary value investor Benjamin Graham. Graham was emphasizing that, while public mood influences short-term stock market pricing activity, fundamental factors like revenue, earnings, cash, and debt determine how a company’s stock performs over time. Using the larger fool principle to generate large returns is possible, but it is risky and far from the best strategy to achieve good long-term performance.
The Greater Fool Theory In Practice
The greater fool concept is typically used as a quick investment strategy. Basically, you’re betting that someone else will come along and buy your goods for a premium price than you paid, with no reason as to why. This thinking assumes that someone else will be swept up in market momentum or will have their own basic reason for why the thing is worth more than you paid.
Anyone who purchases bitcoin without evaluating its use cases, acceptance, or core technology is taking a risk. Their plan is predicated on the expectation that it will be purchased at a higher price later. The greater fool idea is used in this tactic. The experience of this investor may vary depending on when he buys and sells either great earnings or enormous debts.
Additionally, on Greater Fool Theory
The evolution of the US property market over the preceding many decades is another example of the risk-reward dynamics of the larger fool method. According to the Federal Reserve, average inflation-adjusted house prices in the United States quadrupled between 1995 and 2005. Homebuyers who used the larger fool theory were likely to profit if they bought and sold at virtually any point during that time period. There were no repercussions for failing to devote sufficient time and effort to learn the fundamentals and complexity of the real estate market.
If U.S. residents had bought a house in early 2007 with the expectation that the real estate market’s extraordinary pace would continue unchanged, their house’s value would almost certainly have declined. That year, housing prices continued to decrease. It eventually hit rock bottom in 2011 before starting to rise again. The average US home price did not reach its 2007 high until 2013. A “greater idiot” may have eventually appeared, but it took on average six years. Before the fool surfaced, many real estate investors were compelled to sell their properties at a severe loss.
Why Bitcoin Is Important: Disproving the ‘Greater Fool’ Theory
When we discuss bitcoin with investors, they always have a lot of questions: regarding custody, instability, and changing regulatory norms. In general, these issues are easily addressed. Fidelity provides custody, Jane Street runs bitcoin markets, and authorities are becoming more engaged in the field.
However, once you’ve gotten past the obvious concerns, there’s always one more lurking at the back of people’s minds. The thought that they don’t want to bring up for fear of appearing impolite.
What Makes bitcoin valuable in the first place?
This is the argument that has tainted the reputations of several of my personal financial idols, like Warren Buffett and Jack Bogle. “Digital currencies truly have no value,” Buffett said earlier this year in an interview with CNBC. There is nothing you can do with it except sell it.
In business and society, this is regarded as the “greater fool theory.” The concept is that you should never invest in something whose value is exclusively decided by its ability to be sold to someone else for a higher price. According to the notion, stocks, bonds, and real estate generate cash flows that can be utilized to value them. Bitcoin does not generate anything.
A Historical Perspective on Crude Oil
Up until the late 1800s, crude oil was primarily an irritant. When pioneers digging wells for water in the American West discovered oil, they were occasionally disappointed. The problem was that there was no clear function for oil. It might be used to make asphalt on the fringe, and it was commonly used as medicine, but it was mainly neglected. It was about as fascinating as looking for mud in order to discover oil.
When George Bissell made his breakthrough in the 1850s, things began to change. He was curious if rock oil could be refined and used as a light source, or if it might be converted into “coal oil” for kerosene lamps and industrial lubricants. When a researcher realized that a sticky, seepy, and unattractive liquid might be used to generate light, the oil industry was born.
Yet, due to oil shortages, demand remained modest during the first few years. One was that it smelled unpleasant due to the high sulfur content of crude oil. Chemical advancements like gas sweetening, which were funded by oil firms like Standard Oil, created new uses and markets.
The narrative doesn’t really, obviously, end with kerosene lamps. In the early 1900s, designers toyed with internal combustion engines. Oil demand skyrocketed as automobiles transitioned from toys to necessities. By the end of the 1920s, power accounted for 85 percent of total oil production.
More on Crude Oil History
Following the introduction of the kerosene lamp, Bitcoin is now equivalent to oil. This is prior to the invention of vehicles, airplanes, and other modes of mobility. It’s a commodity with a few but significant, practical uses. It is used by individuals to save money outside of the fiat currency system. They transfer money across borders and settle huge transactions in a timely and irreversible manner. It serves as a release valve for citizens concerned about authoritarian governments, as well as a tool for expatriating money in some countries with little physical risk.
Like oil in the late 1800s, these uses are simply scratching the surface of bitcoin’s potential. The advantage of oil is that it can store energy that can be easily transferred and released in a powerful manner. This is exactly what kerosene lights indicate. Likewise, bitcoin’s current utility is limited; its true value stems from its ability to allow money to transfer via broadband internet and be held decentralized.
More Experience From Crude Oil’s Past
Bitcoin investors believe that future use cases based on these essential attributes will be more valuable than Bitcoin’s current market valuation. In my opinion, it is easy to see how this could be the case. For example, if 10% of the wealth currently held in physical gold was converted to bitcoin in the future, each bitcoin would be worth around $50,000. The opportunity is further expanded if bitcoin penetrates areas such as offshore wealth, escrow, payments, remittances, and other sectors.
Those values may appear to be excessive. However, keep in mind that digital reproductions of analog goods are sometimes regarded with mistrust at first. People have begun to doubt the potential of digital media to replace newspapers, digital advertising to compete with print and television, and online retail to compete with physical stores. In each case, time proved them wrong.