Greater Fool Theory - July 30, 2022

Greater Fool Theory
Speaking at a TechCrunch talk, Bill Gates described cryptocurrencies and NFTs as something that’s “100% based on greater fool theory.” So, what is the greater fool theory and how to avoid being a fool?

The greater fool theory suggests that one can make money through buying overvalued assets or assets without any intrinsic value and selling them at a higher price. Thus, one “fool” buys an overpriced asset hoping to sell it to an even “greater fool” and make a profit. That only works until there aren’t any bigger fools left. Finally, the bubble bursts, resulting in a significant decline in the price until it gets closer to its fair value. Sometimes the fair value could be zero.

The greater fool theory can work in a period of economic bubble. However, in the end, speculative bubbles burst. According to Investopediagtht, the greater fool theory breaks down in other circumstances, as well, including during economic recessions and depressions.

Investors acting according to the greater fool theory ignore the quantitative and qualitative characteristics of the business, which is obviously risky. Acting on the basis of the greater fool theory can hardly be referred to as investment. Instead, it is unintelligent speculation, unjustified risk-taking without proper analysis. To avoid being a fool or even a greater fool is quite easy: focus on investing and stay away from unintelligent speculation. Invest on the basis of an in-depth analysis and avoid unreasonable risks.

We would like also to name a few examples of the greater fool theory in action.

  • Cryptocurrencies. They do not multiply, do not produce anything, do not pay dividends, they are not widely accepted as a means of payment. They have no intrinsic value. People buy them only in the hope of being able to sell them at a higher price down the road.
  • NFTs. They will hardly generate any cash flows until they are sold to a new “fool”. NFT, similar to collectibles, can have some value to the individual who buys it. The value can be historical, cultural, emotional and so on. However, we believe they have no value as an investment.
  • Real estate. Investments in real estate are often motivated by the expectation that prices will always go up. The same expectation can result in lenders under-estimating the risk of default. However, we know that the assumption of a constant increase in real estate prices is incorrect. Just think of numerous real-estate bubbles. 
  • Stocks. The greater fool theory applies when investors buy stocks not because they believe that they get enough for their money, but rather because they believe that they will be able to sell them to someone else at an even higher price. This leads to stock market bubbles that end up bursting.
  • Art. Art has a rather limited ability to generate cash flows. The investment decisions here are often driven rather by the expectation of a price increase, not by intrinsic value.

The bottom line

The greater fool theory describes the purely speculative behavior of investors which makes the stock market look like a casino. In our view, this approach has nothing to do with investing. Therefore, it is quite easy not to be a “fool”: focus on investing, that is, on purchasing assets that promise adequate returns and security of capital on the basis of an in-depth analysis.

Disclaimer: This analysis is for general information and is not a recommendation to sell or buy any instrument. Since every investment holds some risk, our main business policy is based on diversification to minimize threats and maximize profits. Innovative Securities’ Profit Max has a diversified portfolio, which contains liquid instruments. This way, our clients can maintain liquidity, while achieving their personal investment goals on the long term.