The greater fool theory of investing is simple to understand. And yet, investors constantly find themselves as the greater fool. Which is not the position you want to be in. Obviously.
What is the greater fool theory of investing?
To understand the greater fool of investing theory, we need to call back to the firm foundation and castle in the air theories.
As a refresher, the firm foundation theory says that every investment has a fundamental value. And that this fundamental value can be approximated using certain variables. (In reality however, it cannot.)
The castle in the air theory says that every investment is worth only as much as someone will pay for it. Basically, the actual value of the investment is meaningless. It is only the perceived value that is important. Believers of this theory posit that they can predict future value from prior buy/sell patterns of the investment. (They can’t.)
The greater fool theory of investing sort of incorporates both of these other hypotheses. It says that the cost of an investment doesn’t matter…as long as you can find a greater fool willing to pay you more for it.
To illustrate this principal, let’s look at some historical examples of investments who’s value was essentially tied to finding a greater fool.
- The Dutch tulip bulb craze in the 1600s
- The British South Company stock fiasco in the 1700s
- The dot com stock bubble of the early 2000s
All of these crazes have a lot in common:
- They all started off with legitimate goods and/or services
- The perceived value of these goods/services skyrocketed
- The perceived value surpassed the fundamental value of the goods/services by any reasonable estimate
- People bought these goods/services in a speculative fashion looking to flip them to a greater fool
- A bubble was born and eventually burst
In these examples, the greater fool played a significant role. It seems easy from the outside to dismiss these past examples. To say that we would be able to be more rational and not fall in the same trap.
However, I would also add the cryptocurrency craze of our current era to this list of greater fool investments.
Why is it so easy to become a greater fool?
There is a massive social component to all investing. This becomes enhanced and magnified when some investment becomes wildly popular and thus experiences a huge spike in (perceived) value.
We don’t want to miss out. We have FOMO.
So we drop our rational senses and jump in. Once we jump, we too realize that we need to find a greater fool. Unfortunately, by the time that investors realize this, they are usually the greatest fool.
Just look at the crazy GameStop saga from last year…
So does this mean that every investment involve a greater fool?
That was the question that I asked myself when I first read about this theory. The answer is my opinion is “No.” Let’s explore why.
Imagine it’s the early 1990s…
A young Jordan is being driven around by his mom from store to store looking for Beanie Babies. Why? Because that’s what everyone is doing. We finally find a store and have to pay $30 for a fabric animal with beads inside.
Is it really worth $30? No reasonable person would say that this fabric and beads is worth $30. But millions of reasonable people paid that and more. Why? We were greater fools. Some of us looking for even greater fools. But all fools nonetheless.
Now, putting aside that extreme but apt example, let’s think about the last investment property that Selenid and I bought…
We bought that property for a higher price than the previous owner had bought it for. (For a full review of the deal analysis of that property, check this out.)
Does that mean that we were the greater fools?
I don’t think so. We bought the property at a price that permits cash flow of greater than 20%. Our appraisal based on income and comparison methods was above the price we paid.
So, we bought a good asset for a fair price that also allowed the seller to profit based on their initial investment.
That’s a win-win. And, I believe, the hallmark of sound investing.
Let’s look at the stock market as well
I invest in low cost, broadly diversified index funds. Every 2 weeks, I buy more of the same funds according to my asset allocation regardless if the market is up, down, or sideways.
When I buy these funds, someone else is selling them. And sometimes, they sell them to me for a higher price than they bought them. Am I the greater fool? Well, despite buying at a higher price, I argue that I am not.
Whoever sold me the shares likely bought and held them for some time. They likely bought at a fair price in the past, experienced appreciation based on long term overall market gains, and then sold to me at a fair price. And I have a plan to do the exact same thing.
Now, this doesn’t define every index fund transaction, but for long term buy and hold investors, this is the trend that you are taking advantage of.
How to avoid becoming the greater fool
This is the goal. In fact, I would broaden it even further by saying that we want to invest in a manner that doesn’t require us to find the greater fool either. That is speculating, not investing.
And I think it can be as simple as just asking yourself these questions before investing in something.
- For the person selling me the investment to be successful, do they need to find a greater fool?
- For me to be successful with this investment, does it require me to find a greater fool?
If the answer to either one of these question is “yes,” then that is not a good investment.
If the answer to both is “no,” then evaluate the investment further to see if it fits your plan.
For example, my main investment vehicles in elevating my net worth and reaching financial freedom are:
- Paying off my debt for immediate returns,
- Investing in low cost broadly diversified index funds for the long term, and
- Buying cash flowing rental properties using a buy and hold strategy
None of these investments is dependent on a greater fool (me or them) to be successful.
Then, use your personal financial plan to protect yourself
Once you establish which “greater fool-proof” investments will help you reach your financial goals, cement them into a written personal financial plan.
Because you can be sure that some other “greater fool” investment will come along in the future. And you will be tempted by it. You will feel FOMO. You will think, “This is different.”
I know this because I have felt it as well. And every time, I look back at my written financial plan. Then I remember that all I have to do is follow this plan and I will reach my financial goals including financial freedom.
Suddenly, that exciting investment opportunity doesn’t carry the same water.
What do you think? Do you believe the greater fool theory of investing? Do any of your investments require a greater fool? Let me know in the comments below!