What is the Greater Fool Theory?
Examples of Greater Fool Theory
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Example #1
When formed by using irrational valuations instead of looking at the investment’s intrinsic valueIntrinsic ValueIntrinsic value is defined as the net present value of all future free cash flows to equity (FCFE) generated by a company over the course of its existence. It reflects the true value of the company that underlies the stock, i.e. the amount of money that might be received if the company and all of its assets were sold today.read more, the speculative bubbles will burst and lead to a crisis. For example, the financial crisis of 2008, where people took loans from the banks to buy houses in the hope of selling these houses at a higher price in the future to make substantial gains. It worked for years until the supply of fools. That eventually, someday, began to dry up. As more people began to see the asset’s intrinsic value and suddenly, the mortgage takers could not find buyers, banks wrote up a huge amount of credit granted to these buyers off their balance sheets. This event leads to the banking emergency and eventually to the financial crisisFinancial CrisisThe term “financial crisis” refers to a situation in which the market’s key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more.
Example #2
In the stock marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price.read more, this theory applies too, when many investors invest in a not-so-profitable company, assuming that it will be sold later at a higher profit to a greater fool. Investment in any stock is not made by looking at its intrinsic value and potential to provide higher returns. Rather, it is made on assumptions that someone is there to buy it at a higher price. It is called survivor investing.
Bitcoin and Greater Fool Theory
Bitcoin was a great investment. It is a pure example of a greater fool theory type of investment where you are not producing anything but only expecting it to increase depending on the investment made by others. It works on the same principle of the greater fool theory, which suggests the cycle will continue with hopes of getting a higher buy price. One can short Bitcoin by using future contracts on the world’s leading derivatives marketplace. Bitcoin works on the Ethereum blockchain system. These cryptocurrencies are the gold standardGold StandardThe gold standard was a monetary term used when gold exchange was used instead of paper currency.read more. People who buy bitcoin expect other people to buy them at a relatively higher price. But the reality is that bitcoins are the deflationary coins or currencies that people hold for the long term. Bitcoin should not be looked at as a financial tool because it is blockchain technology. In a nutshell, bitcoins are non-productive assets that completely work at the mercy of others to buy and raise their price.
Greater Fool Theory Investing
Greater fool theory is used to design an investing strategyInvesting StrategyInvestment strategies assist investors in determining where and how to invest based on their expected return, risk appetite, corpus amount, holding period, retirement age, industry of choice, and so on.read more that is based on the belief that an individual can always sell an asset or security at a higher price as compared to the purchase price to a greater fool who is willing to pay a higher price based on unjustified multiples of security instead of looking at its intrinsic value. The whole idea is to make money by speculating the increase in future prices irrespective of market conditions. This theory works based on the assumption that there is not a single fool in the market but many. This investing approach determines the likelihood that one can sell an investment of one individual to others at a higher price than what has been paid. This investing mechanism focuses on forming speculative bubbles, which may burst someday and lead to a crisis. It does not always promise to give higher returns and may even prove fatal for the investors as it does not work on an asset’s intrinsic value and its prospects to earn a higher yield in the future.
How to Avoid Being a Greater Fool?
- One should understand that there is nothing predictable with 100% accuracy in the securities market. The market works on the order of diverse trends, and nothing is certain in the market. For example, the price of an asset that is higher today may either inflate in the future or decrease drastically based on market conditions.One must diversify the portfolio. Also, one must include various securities and assets in the portfolio based on their past performance and credibility.Before investing, one should conduct thorough research, planning, and market analysis. Then, a proper strategy must be developed and implemented. Finally, one must adopt a long-term investment approach to avoid speculative bubbles.The common herd should not be followed by paying higher prices for something without a good reason because others are investing. The self-decision must be taken before investing, and one must eliminate greed and the temptation to make big money in a short period.
Conclusion
Greater fool theory is an investment mechanism that makes an investor purchase overvalued security without regard to its quality, making it a greater fool that leads to speculative bubbles. One must follow due diligence to avoid becoming a greater fool. You must always evaluate an intrinsic value of an asset or security for investment considerations.
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