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Concept: The Greater Fool Theory

Gunnar Jaerv
Gunnar Jaerv 20 May 2021

The greater fool theory states that as an investor, you can buy stocks or other investment targets that are clearly over-valued, and still make money.

How can you make money by buying things for more than they’re worth? Because there’s always a greater fool to whom you can sell them on for even more.

Eventually, the market will come to consist more and more of “greater fool” investors, they will run out of such greater fools to sell to, and prices will sell off, sometimes precipitously.

Greater fool theory is a method of investing in bubbles and overheated markets in such a way as to derive income from them even when they are headed for disaster, or at least sharp corrections. For this reason it’s sometimes referred to as “survival investing”.

Pricing the greater fool

As a theory, it’s derived from game theory, and the objective is to participate without being the player who eventually suffers the penalty. You’re passing that on to the next purchaser — the “greater fool”. In this sense it’s reminiscent of games we all know like musical chairs or pass the parcel.

It’s also a way of understanding price. Price is one of those things that stays simple as long as you don’t look at it, and in our day-to-day lives as consumers, it is relatively simple. Enter a store, browse a clothing or electronics website, and pricing is clearly displayed.

But in finance, and economics too, price isn’t so clear. We’ve spoken before about the attitudes some of the founders of modern economics held towards price: Adam Smith developed a sophisticated theory of price that took into account markets, labour and materials.

Later, John Maynard Keynes developed a concept he referred to as “beauty contest investing”: imagine a beauty contest in which the judges select, not the contestant they find most beautiful, but the one they believe all the other judges will choose. Apply this to equities markets and you come close to greater fool theory.

A more conventional method of assessing price would be quality: degree and duration of utility. You buy brand name rather than off-brand power tools because they work better (higher degree of utility) and last longer (duration of utility). In the same way, a higher-quality investment does more of what it’s supposed to do — deliver returns — and it does it for longer, more reliably and predictably.

Others believe the price of a thing is what you can get for it, or what you can get away with paying for it.

Rather than looking upstream for price, at costs of production, greater fool theory encourages us to look downstream to resale. Price, in these terms, is what you can reasonably expect to sell something for. If the price you must pay is lower than this, it’s a good investment. It also encourages us to disregard quality; even junk investments are worth buying if they can then be sold for more as the market in general rises.

Value and the market

The risks of this strategy are obvious. How can you make sure you aren’t left holding the bag? How can you be sure you aren’t yourself the greater fool? And how much “fool-greater fool divergence” is acceptable?

If there were suddenly a booming market in pieces of gravel, easily replaceable and more or less completely worthless, there would be a great divergence between canny investors and “greater fools”. If you can buy gravel for $1,000 per piece and sell it for $1,000,000 per piece, you’re making huge profits — but with the risk that the market suddenly collapses and leaves you heavily committed to valueless rocks. There’s a strong degree of divergence there.

On the other hand, if you’re buying stocks in a successful company like Apple at slightly under their “true” valuation, and selling them for slightly over, you might hope for a greater fool — but if one doesn’t come along, you won’t be ruined.

Due diligence and planning

Making sure that you aren’t the greater fool yourself is about spotting patterns in the market and about due diligence. It’s also about long-term investment planning and portfolio diversification.

Long term investment strategies should take account of the likelihood that overheated markets will arise, and should offer methods to stop them from derailing your strategy. These include avoiding excessive investment in short-term opportunities — and greater fool investment is by definition a short-term investment.

Portfolio diversification should work to prevent excessive exposure to any single market or product, and include long term and store of value or safe haven investments, with appropriately managed risk.

Due diligence should give you a window into intrinsic valuation, which should in turn let you know whether you’re buying stocks in Apple or a worthless pile of gravel.

Intrinsic quality and price

One of the distinguishing characteristics of the 2008 subprime mortgage crash was the packaging and sale, repackaging and resale, of debt which was intrinsically of low quality; home ownership peaked in 2004 and fell thereafter, exposing the debtors of the underlying debt to circumstances that made them unable to service their debts, default and declare bankruptcy.

At that point, securities and investment firms realized, too late, the poor intrinsic valuation of the mortgage-backed securities into which many had invested millions on the basis of the willingness of other investors to buy — not on the basis of underlying asset quality.

Due diligence might have discovered this discrepancy. Such due diligence could include calculations of market cap and total value, and identifying revenue, profit, and margin trends.

But it could also include researching competitors and industry and market trends, as well as contextualizing the investment with PE (Price-Earnings), P/S (Price/Sales), and PEG (Price/Earnings-to-Growth) calculations. Management and company ownership should also be taken into account.

The key point is to identify distance between market direction and underlying value. If you identify an investment as being of poor quality, but simultaneously see that market trends mean you’re likely to be able to sell it for more than its current asking price, that’s “greater fool” investing. If you see only the direction of market price without figuring the risk, you’re joining a game of musical chairs; we learned in 2008 what can happen when the music stops.

Disclaimer:

Disclaimer: This publication is general in nature and is not intended to constitute any professional advice or an offer or solicitation to buy or sell any financial or investment products. You should seek separate professional advice before taking any action in relation to the matters dealt with in this publication. Please note our full disclaimer here.

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