Greater Fool Theory - Explained
What is the Greater Fool Theory?
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Table of ContentsWhat is the Greater Fool Theory?How Does the Greater Fool Theory Work?Example of How the Greater Fool Theory WorksGreater Fool Theory vs. Intrinsic Valuation
What is the Greater Fool Theory?
Greater fool theory is an assumption that there is a possibility of making money by purchasing securities and selling them at a later date, whether they are overvalued or not. In other words, there is that individual (greater fool) in the security market who is ready to foolishly push the price further higher even for an overvalued security.
How Does the Greater Fool Theory Work?
In economics and finance, this theory asserts that the objects price is determined by foolish beliefs and expectations of participants in the market and not intrinsic value. In that case, a rational buyer can justify price under the conviction that another entity is ready to pay a higher price than the current one. In the stock market, investors apply this theory by making a doubtful investment with the hope that they will later sell the securities to a greater fool. What they do is to buy shares not because it is worth the price but because they hope to sell them to other individuals at a much higher price than what they paid for. Real estate investors use greater fool theory to see their investment through the hope that there will be a price increase in the future. Lenders are likely to underestimate the default risk during a period when the price seems to rise.
Example of How the Greater Fool Theory Works
A good example of a scheme that uses great fool theory is the Ponzi. Investors who are in this rely on a continuous supply of greater fools who are ready to buy into it. The scheme pays earlier investors the money that they generate from the recent ones. To maintain its float, the scheme depends on greater fools who are ready to invest in it. It is worth noting the scheme has any value, provided that the greater fools invest in it, and investors continue to earn the profit.
Greater Fool Theory vs. Intrinsic Valuation
During the 2008 financial crisis, finding buyers for the mortgage-backed securities was not easy. The reason is that securities were built on poor quality debt. To determine the value of an investment, it is important to conduct in-depth research, including the type of valuation model you intend to use. Conducting thorough research ensures that the qualitative and quantitative analyses you use will give you the actual picture of how the investment looks like. The aspects of these two analyses include:
- Calculating the capitalization or total value of a company
- Identifying profit, revenue, margin trends, and profit
- Researching industry trends and competitors
- Placing the investment in a wider market perspective