You’d probably call me crazy if I told you that I bought a regular pen for $50. A rational person would never buy something he knows is so wildly overpriced. Why, then, did I buy the pen at such an outrageous amount, you ask?
The reason is obvious. I bought a pen for $50 because I’m hoping to sell it to someone for $51, thereby making a profit of one dollar out of the total transaction. People often buy stuff at unreasonable prices because they hope to sell it at an even higher price to someone else.
For most people, the conversation ends here. However, economists ask a follow-up question, “Why would someone else buy it at $51?” It’s probably because they, too, think that they can find a buyer willing to pay more for it.
This begs the question… is it really possible to make money by buying overpriced assets and selling them later at a higher price?
What Is The Greater Fool Theory?
The greater fool theory, which is a theory in finance and economics, states that it is indeed possible to make money by buying assets (even when they’re overpriced) and selling them at a profit, as you will always be able to find someone willing to pay a higher price.
This theory is very common among investors who invest or trade in company stocks. An investor who—knowingly or unknowingly—subscribes to the greater fool theory would buy potentially overvalued assets without regard to the assets’ fundamental worth. He would typically think, “I am a fool to buy it at such an exorbitant price, but I will find a greater fool who will be willing to pay more than I did.”
At a fundamental level, the price of a given stock is usually the result of various market forces (demand and supply), the company’s current strength (earnings) and its expected growth in the future (Source).
However, sometimes a stock in the market becomes too attractive and its price skyrockets so much that it is being driven solely by the expectation that it will always be possible to find buyers for the stock, rather than being driven by the intrinsic value, i.e., cash flows and earnings of the company. It does not matter what the stock is actually worth; it only matters how much someone will pay for it in the future. In such a situation, the presumed existence of buyers justifies any price, no matter how unreasonable.
A good example of the greater fool theory is the recent Bitcoin craze.
Bitcoin and the Greater Fool Theory
Bitcoins have been occasionally making headlines for a few years now, stirring up many discussions and debates about their profitability and value. A logical question is: why are they valued so highly by the market?
Typically, the value of an asset would be calculated by considering the returns it will give. For stocks, this is a dividend. However, since Bitcoin will never pay dividends or returns, its value as an asset is zero. Alternatively, we could think of it as a commodity (such as oil or gold), whose value is based on its inherent value. The inherent value of gold, for example, would depend on its utility as a metal and its usefulness as decoration, and that value is further increased by its scarcity. Bitcoin does not have any such inherent value. Therefore, even by this approach, its value should be equal to zero.
We could value it as a currency, but the value of currency depends primarily on its ability to be exchanged for goods and services. Bitcoin cannot be effectively used for this purpose either, and thus has no value as a currency (Source).
Regardless of that, Bitcoin is trading at more than $10,000… What is driving Bitcoin’s value?
Bitcoin’s value is mainly driven by the expected price next year. Investors (bitcoin-holders) believe that the value of bitcoin will go up in the future, due to which they will be able to sell it for a higher price. This is therefore a classic case of the greater fool theory.
At this point, you must think that this theory seems too good to be true. If it was so easy to make money, why don’t we see people constantly getting rich with the help of this theory? Isn’t the greater fool theory fool-proof?
For the greater fool theory to hold true at all times, the price of an asset would have to keep increasing indefinitely. However, the truth is that nothing lasts forever—not even rising prices.
Let’s look at exactly what happens in this type of situation!
What Are Market Bubbles?
Market bubbles are self-sustaining waves of optimism in which prices of specific assets/stocks rise dramatically over a short period of time and increase far beyond their fundamental values. During a market bubble, the popularity of a certain asset/stock increases beyond normal limits. Everyone wants a piece of the action, and is willing to pay large sums of money to acquire the oh-so-popular stock. With no dearth of buyers, the greater fool theory perpetually manifests itself during these times.
However, like any other bubble, a market bubble eventually pops. Reality sets in as the first hints of doubt quickly turn into a panic. Everyone holding the stocks runs for the exit door at the same time, but there are no buyers to find. In other words, there are no greater fools in the market to sell the stock to, so the people who hold the stocks at the time of the crash ultimately end up being the greater fools themselves.
In short, the behavior supported by the greater fool theory only continues until the asset is sold to the greatest fool who is unable to find any new buyers. Eventually, the value of the asset must drop to its fundamental value, as the speed and magnitude of a crash mirror the formation and rise of the bubble in the first place.
Mean Reversion: Should You Ever Try To Use The Greater Fool Strategy?
Despite the risk, there is abundant evidence that greater fools actually exist. However, successful implementation of this strategy requires a lot of skill and is highly time-intensive. Stock prices usually behave in a manner of what professionals call ‘mean reverting’, which is to say that stock prices move around, but they eventually move back to their average (mean) price. Investors must constantly pay close attention to market behavior, because the price trends can reverse in a matter of seconds.
Even so, no one has a crystal ball to predict exactly when a bubble will burst or a mean reversion will occur. Thus, the greater fool theory is a matter of speculation, a sort of gambling, and not a sure-shot strategy that can be relied upon in every instance.