The greater fool theory in investments refers to those investors who buy an investment based on the thinking that they will be able to sell it at a profit to a “greater fool”. So in a way, they say I am a fool too and I am looking for an another great fool.
The classic example of Greater Fools Theory in investments is the Real Estate Bubble. People thought that this one is a great asset class, so they sold other financial assets and booked 3-5 flats. They even took multiple loans, thinking that soon they will find a greater fool and they could make some good money.
The result is in front of us. A recent CII report says that on an average the top 10 cities have unsold flats in the range of 23-45%. Same happens in equity markets also.
People have bought Dmart (Avenue Supermarts) at 100 time P/E to its FY17 earnings. These very same people say Nifty is overvalued at 23 P/E. Same is happening in the IPO rush currently going on. Watch how some companies are overpricing their issues. Because they also believe in the Greater Fools Theory.
Here is a folk tail which describes this theory:
Long ago…in a village infested with monkeys…a trader came and announced he’d buy monkeys for Rs 500.
The news caught on. And more and more villagers were catching monkeys to make a quick buck.
After a few days, the trader hiked the buy price to Rs 2,000. The villagers fought over the remaining monkeys. And when the trader hiked the buy price to Rs 5,000, the villagers began risking their lives going deep into the dense forest to catch more monkeys.
Before long, no more monkeys were to be found in the village or the forest. That’s when the trader announced he’d buy monkeys for Rs 10,000 on his return to the village in a week.
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The villagers felt sad and helpless that they couldn’t take advantage of the opportunity.
But the trader’s employee…supposedly acting on his own…told the villagers that he would secretly sell some of the trader’s caged monkeys back to them for Rs 7,000 each.
Realizing they could still earn a net profit of Rs 3,000, the villagers queued up to buy the monkeys from the trader’s employee.
While the rich villagers bought many monkeys, even the poor ones borrowed money to make the most of the opportunity.
As the news spread, people from villages far and wide turned up to buy the remaining monkeys. Then they all waited patiently for the trader to return and buy the monkeys for Rs 10,000 each.
But the trader never returned.
The villagers were left with monkeys and a loss of Rs 7,000 on each one.
Perhaps you’ve heard this story before. Economists describe the villager’s behavior as ‘the greater fool theory’.
And now after a folk tale a true story:
During the Great Depression (1929 to 1941), Franklin Roosevelt (then US President), could avoid huge losses on his portfolio when one day while he was on his way to the office, he heard his liftman recommending on the best of the stocks to buy.
Immediately as he reached office, he called up his broker and instructed him to sell all his stocks. It was Wednesday.
The next day was 29th October 1929 and is marked in history as Black Thursday till date. This was the day when the US Stock Market crashed like never before and what triggered the Great Depression in the world economy that lasted for more than 10 years. People lost a huge amount of money going bankrupt in most cases (Losses for the month did total $16 billion, an astronomical sum in those days).
President Roosevelts decision to sell stocks one day before the crash laid foundations of this theory, which we now see in textbooks as The Greater Fools Theory.
When a type of investment does very well for a long time, it attracts investors. Many feel they’re missing out on something good. But speculation in any type of asset, including houses, usually ends badly.
When the price of an investment rises for a long time, it eventually becomes overpriced. Nevertheless, some people are willing to buy because they feel they missed out. They themselves acknowledge that they’re a ‘fool’ to pay such an inflated price for the asset. But, they expect an even ‘greater fool’ exist to take it off their hands at an even higher price.
Here is a great Youtube Video which speaks about:
- How Chinese army trains their soldiers using The Great Fools Theory.
- The tulip mania of 17th century
- Benjamin Graham words of wisdom
The Greater Fools Theory has following disadvantages:
- You start chasing price and not the valuation.
- Your portfolio gets concentrated and increases risk.
- You lose value buying opportunities.
Avoiding the “greater fools theory investments”?
- Many people are buying like crazy and saying is to be a “sure shot”. If this sort of risk is what you’re interested in – yes you are making a fool of yourself. Simplest way remove all emotion from your investing is to have a plan.
- Do your homework! The key to making any knowledgeable investment decision is to first do your research on the scheme and company in which you would like to enter.
- Diversify your portfolio by investing in multiple asset and sub-assets. Diversifying your investments is the way to do so. Use the power of multiple portfolios.
- The Greater Fool Theory is mainly concentrated in market bubbles. So if you focus on research and long-term investing strategies, you’ll be less likely to be in losses.
- There’s no need to make rushed decisions. There will always be opportunities in the market for you to take advantage of. Be patient, because opportunities keep coming and going, but you don’t have to jump on every passing train.
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