The greater fool theory is simply this: Even if doing X doesn’t make sense, there is always someone dumber than me I can sell X to. Replace X with inflated real estate, sub-prime mortgages, stocks, garage sell junk, etc. This is the crux of bubble thinking. The major problem with this theory is that someone is always the greatest fool. It may not be you this time, but keep playing Russian roulette with deals that don’t make sense and it will be.
I learned of the greater fool theory first hand as an undergraduate in college. In the bubble year of 2000, I started my first online stock trading account with a hard earned $2,000 from my summer internship. I had a run of success you would not believe with a very simple (and very stupid) strategy. The strategy: watch what Internet firms report positive earnings, and then buy. Obviously I didn’t have a good concept of a DCF model or really understand what a P/E ratio was, but I did know that I was making a killing. In a matter of weeks I was almost up to $20,000.
Little did I know that I was simply profiting off the greater fool theory. Every stock I was investing in was insanely overvalued. With no real fundamental values to hang their hat on, the stocks in my portfolio fell as quickly as they rose. When all was said and done I had less than $500. I went from hero to goat in a matter weeks, wondering where I went wrong.
I am sure most seasoned investors have a similar war story. However, most new investors feel invincible. The problem with most new investors is that they have not gotten caught up in the frenzy of investing. It’s something akin to lemmings, when investors continuing buying even though they know there is no justification for their high valuations. Eventually, the first lemming falls off a cliff (sub-prime lending perhaps?) with the others soon to follow.
The question is why so many investors lose their grasp on the fundamentals? The irony is that it is usually fear of being considered a fool. Think about how “dumb” all the people are who passed on Google at $300 or how “dumb” all of those caution mortgage companies were to avoid the sub-prime lending. Even though investors know the pricing of these instruments is clearly irrational, they fear missing out on the next big thing. These same investors will be deriding the market for overvaluing these investments when they fall.
The solution to avoiding this problem is twofold. First, never think you are smarter than the market. While you may be smarter than me and the next person, the market always wins out because of the law of averages and the herd mentality. Second, hold fast to your investment principles. Always have an investment standard and process. More importantly, stick to it. Avoid emotional investing and stay away from the herd. If something doesn’t make sense, do not do it.
There is always a greater fool out there. Try to avoid it being you.2 comments