Greater fool theory

In finance, the greater fool theory suggests that one can sometimes make money through the purchase of overvalued assets — items with a purchase price drastically exceeding the intrinsic value — if those assets can later be resold at an even higher price.

In this context, one "fool" might pay for an overpriced asset, hoping that he can sell it to an even "greater fool" and make a profit. This only works as long as there are enough new "greater fools" willing to pay higher and higher prices for the asset. Eventually, investors can no longer deny that the price is out of touch with reality, at which point a sell-off can cause the price to drop significantly until it is closer to its fair value, which in some cases could be zero.[1][2][3][4]

Crowd psychology

Due to biases in human behavior, some people are drawn to assets whose price they see increasing, however irrational it might be.[5] This effect is often further exacerbated by herd mentality, whereby people hear stories of others who bought in early and made big profits, causing those who did not buy to feel a fear of missing out.

Examples

In times of hyper-inflation and in remote regions the price of necessities is so exorbitant that relative to normal markets these prices may seem arbitrary. Yet the local cost of doing business relative to the price in these regions, as well as the necessity to feed and shelter one's self in a hyper-inflationary crisis, justifies through profit or actual benefit the "foolish" price.

In real estate, the greater fool theory can drive investment through the expectation that prices always rise.[6][7] A period of rising prices may cause lenders to underestimate the risk of default.[8]

In the stock market, the greater fool theory applies when many investors make a questionable investment, with the assumption that they will be able to sell it later to "a greater fool". In other words, they buy something not because they believe that it is worth the price, but rather because they believe that they will be able to sell it to someone else at an even higher price.[9] It is also called survivor investing. It is similar in concept to the Keynesian beauty contest principle of stock investing.

Art is another commodity in which speculation and privileged access drive prices, not intrinsic value. In November 2013, hedge fund manager Steven A. Cohen of SAC Capital was selling at auction artworks that he had only recently acquired through private transactions. Works included paintings by Gerhard Richter and Rudolf Stingel and a sculpture by Cy Twombly. They were expected to sell for up to $80 million. In reporting the sale, The New York Times noted that "Ever the trader, Mr. Cohen is also taking advantage of today’s active art market where new collectors will often pay far more for artworks than they are worth."[10]

Cryptocurrencies have been characterized as examples of the greater fool theory.[11][12][13] Numerous economists, including several Nobel laureates, have described cryptocurrency as having no intrinsic value whatsoever.[14][15][16][17]

See also

References
  1. "Greater Fool Theory Definition - What is Greater Fool Theory?". Investorglossary.com. Retrieved 2015-03-06.
  2. "What is greater fool theory? definition and meaning". Businessdictionary.com. Archived from the original on 2007-12-23. Retrieved 2015-03-06.
  3. Fox, Justin (2001-06-11). "When Bubbles Burst Tulips. Dot-coms. Hey, manias happen. But most don't lead to economic disaster. - June 11, 2001". Money.cnn.com. Retrieved 2015-03-06.
  4. Bogan, Vicki. "The Greater Fool Theory: What is it?" (PDF).{{cite web}}: CS1 maint: url-status (link)
  5. "Oxford Business Review - The Greater Fool Theory". Oxford Business Review. 2020-12-30. Retrieved 2021-11-07.
  6. "`Greater Fool Theory` Can Lead To Expensive Home Investment - Chicago Tribune". Articles.chicagotribune.com. 1986-07-12. Retrieved 2015-03-06.
  7. "What is the Greater Fool Theory? (with pictures)". Wisegeek.com. 2015-02-17. Retrieved 2015-03-06.
  8. "The Greater Fool Theory: Managing and Modeling Risk - The Finance Professionals' Post". Post.nyssa.org. 2010-07-21. Retrieved 2015-03-06.
  9. "Greater Fool Theory Definition". Investopedia. Retrieved 2015-03-06.
  10. Vogel, Carol; Lattman, Peter (2013-10-30). "Steven A, Cohen to Sell Works at Sothebys and Christies". The New York Times. Retrieved 2015-03-06.
  11. "...some of the observed behavior of investors has appeared to fit the ‘greater fool theory’ in that their valuations of Bitcoin seemed based on a belief in a continued upward trajectory." Polasik, Michal; Piotrowska, Anna Iwona; Wisniewski, Tomasz Piotr; Kotkowski, Radoslaw and Lightfoot, Geoffrey (2015). Price Fluctuations and the Use of Bitcoin: An Empirical Inquiry. International Journal of Electronic Commerce, 20(1) pp. 9–49.
  12. "Anyone who bought Bitcoin in the last two months of 2017, when the price reached almost $20,000, has been played for a greater fool." Andreas Andriano, ??? (2018). A Short History of Crypto Euphoria. Finance & Development, June 2018, pp. 20-21
  13. 'In the conclusion, we discuss Bitcoin’s future and conclude that Bitcoin may change from a short-term profit investment to a more steady industry as we identify Bitcoin with the “greater fool theory,”...' Merrick Wang, "Bitcoin and its impact on the economy", 3 Oct 2020, Arvix.com
  14. Quiggin, John (16 April 2013). "The Bitcoin Bubble and a Bad Hypothesis". The National Interest. Archived from the original on 22 October 2014.
  15. Shiller, Robert (1 March 2014). "In Search of a Stable Electronic Currency". New York Times. Archived from the original on 24 October 2014.
  16. Costelloe, Kevin (November 29, 2017). "Bitcoin 'Ought to Be Outlawed,' Nobel Prize Winner Stiglitz Says". Bloomberg. Archived from the original on 2018-06-12. It doesn’t serve any socially useful function.
  17. Wolff-Mann, Ethan (April 27, 2018). "'Only good for drug dealers': More Nobel prize winners snub bitcoin". Yahoo Finance. Archived from the original on 2018-06-12.
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