What You Need To Know About The Greater Fool Theory

No doubt you’ve heard stories of people who lose all their savings by investing in crypto, stocks, real estate, and more. It’s a scary prospect, but there are strategies you can put in place to ensure you don’t become one of these unlucky people.

In fact, there is one important concept that everyone should be aware of when choosing their investments: the greater fool theory.

Everyone wants to be that person who jumps on a hot investment early and makes the big bucks over time. And the greater fool theory might be able to help you with that! Let’s take a look.

What Is The Greater Fool Theory?

Under the greater fool theory, an investor believes they can profit through buying an overvalued asset where the asset's price greatly exceeds its intrinsic value. This investor believes they can then sell the asset at a higher price.

This is the “fool” of the greater fool theory (GFT). Not only are they foolish enough to purchase an overpriced asset, but they believe they can make a profit by selling it to an even “greater fool”.

In simple terms: they do not buy an asset because they believe in its inherent value, but because they believe they can sell it off at a higher price. But this tactic only works if there is a greater fool to buy the asset.

Of course, in real life there is always a point when the crowd of “fools” realize the asset is overvalued and stop purchasing, causing the price to fall or crash.

Examples of The GFT

One of the most recent examples of the GFT playing out in real life was the housing boom of the 2000s. Investors were flocking to invest in overvalued real estate because they knew that someone else would pay a higher price.

You also see the same thing with crypto and NFTs, where people are purchasing virtually everything that hits the market so they can sell them.

The GFT is an interesting theory because you have to consider where you are in the line of fools: Are you the original fool? Are you halfway down the line of fools? Are you the greatest fool who has no one else to sell to? After all, you could be the very last person willing to buy at an exorbitant price, and that’s not a good place to be.

What You Should Know

The GFT may sound like an inherently negative prospect for investors, but this isn’t necessarily the case. You may find a way for this theory to fit into your investment strategy and help you make more money. It’s entirely possible!

But if you are choosing to invest in an overvalued asset with the hope that a greater fool will purchase it from you, here’s what you should know first:

1. Understand That You Are Essentially Gambling

By utilizing this theory, you are making the assumption (or hoping) that there is a group of investors out there willing to purchase these assets at a higher price. Because you don’t know when the bubble is going to burst, you are gambling on the chance that it will continue to grow enough to allow you to sell the asset.

2. The Economy Will Play a Part

When the economy is going strong and money is abundant, investing like this is easy. But when recession comes around, these intrinsically valueless (or atleast, overvalued) assets are the first ones to crash. It’s important to remember that when the economy isn’t doing well, these assets are essentially worthless.

3. Assets Are Based On Fads

So many assets that are bought and sold under the GFT are popular because of fads and trends.

For example, the at-home fitness equipment company Peloton was selling for $20-30 per share before the pandemic. Once Covid hit and billions of people were stuck at home and needed to exercise, this company’s products soared in popularity to $175 per share.

And of course, when things went back to normal and Peloton’s popularity waned, those same shares dropped down to $50. Everyone knew the company wasn’t worth $175, but they purchased it anyway because they knew other people would buy them (for the meantime anyway). But when reality kicks in, these assets will drop in value like a stack of bricks.

4. Be Wary Of Assets That Can Saturate The Market

Let’s look at NFTs - at the moment, NFTs are hot and it seems like everyone wants to invest in them in order to sell them. But NFTs aren’t hard to make, which means that eventually the market will be flooded with them, and it will be hard to identify which ones are more valuable than others.

5. Media Coverage

Media coverage plays a huge role in deciding which assets get the most investment, regardless of their intrinsic value. If you are investing in an overvalued asset, whether or not the media is covering it, and how the media is covering it, will dictate how well it sells.

6. Social Media

Social media is influencing investors more than ever before. It’s very easy for social media influencers to convince hoards of people to invest in an asset that they are already invested in, creating more “fools” to purchase the assets that they want to sell. So be careful when investing based on the advice of social media influencers.

Whether it’s a stock, crypto, real estate, or art, the greater fool theory is being played out all over the place. You can see people everywhere purchasing overvalued assets with the intention of selling them to someone else at a higher price.

Whenever you are investing in popular assets, it’s important to consider the greater fools theory - are you the first fool that is going to make money? Or are you the greater fool who will potentially be left with overvalued assets you have to sell at a loss? The answer should help you figure out the most advantageous decision to make.