What Is the Greater Fool Theory?

When it comes to selling an asset at a higher price than it’s truly worth, there’s always a fool who will buy it. That, in essence, is the greater fool theory. In a nutshell, it states that investors can sell any asset at an inflated price, so long as they can find a “greater fool” who will pay it. 

The greater fool theory is a short-term approach to investing, and it’s by no means a fundamental law. Let’s take a look at this theory and see where it holds up and where it falls short. 

What is the greater fool theory?

The greater fool theory is the idea that investors can achieve positive returns by purchasing assets (such as stocks, cryptocurrencies, or even real estate property) and selling them at higher prices without concern for the asset’s true value. 

In other words, it doesn’t matter what the asset is really worth. The asset could be a stock whose underlying company has a flawed business model, or it could be a home with a leaky roof and a faulty foundation. So long as there’s enough hype around the asset, the greater fool investor assumes they can find someone who will pay a higher price.

Greater fool investors are often contrasted with value investors. A value investor uses fundamental analysis to identify stocks that are trading below their true value. The idea is that by buying stocks at a discount, value investors achieve positive returns when the market recognizes the stock’s true worth. 

Greater fool investors rarely use fundamental analysis to evaluate a stock. Their approach is more subjective. So long as they can find a buyer willing to pay a higher price, they’ll invest in the asset, no matter how much the asset is truly worth. 

The greater fool theory isn’t limited to investments, however. Any commodity can show the greater fool theory in action. In fact, one of the clearest examples of the greater fool theory is new technology. Often, when new technology is released in limited quantities, it intensifies demand among consumers. Certain savvy consumers might then buy new technology at a list price, then turn around and sell it at a higher “street” price.  

Does the greater fool theory work?

The greater fool theory does not always work, and it can come back to haunt the investor, should they fail to find a buyer for their overvalued asset (thus becoming the greater fool themselves). 

In order for the greater fool theory to work, there needs to be a sufficient amount of build-up around an asset. In other words, there need to be a lot of “fools” who will pay a high price. If there is, these fools likely won’t pay attention to the asset’s true worth. They’ll ride the momentum, paying the higher price simply because there’s enough demand around it. 

Of course, at a certain point, investors will catch on to the inflated price. After all, not everyone is a fool. And if the tide turns against an asset, if investors begin to refuse to pay high prices, the asset’s bubble will burst. At that point, whoever paid the highest price will be the real fool: they’ll have to sell it for a lower price, thus taking a loss. 

When does the greater fool theory apply?

The greater fool theory applies in various instances, primarily within financial markets and investment strategies. Here are a few instances where the theory often applies:

1. Speculative Bubbles: During speculative bubbles, assets can become highly overvalued as buyers continue to purchase them with the expectation that they can sell them at even higher prices. This cycle continues until there are no longer any buyers willing to pay the inflated prices, leading to a rapid decrease in asset prices. The dot-com bubble of the late 1990s and early 2000s is a prime example, where investors kept buying overvalued tech stocks believing they could sell them at a higher price.

2. Real Estate Markets: In hot real estate markets, the theory can be seen when investors purchase properties at high prices, expecting to sell them at an even higher price. This can work until the market cools or corrects, leaving some investors with properties valued less than the purchase price.

3. Cryptocurrency: The cryptocurrency market, known for its volatility and speculative nature, often sees instances of the Greater Fool theory in action. Investors may buy cryptocurrencies at high prices, hoping that their value will increase and that they can sell them to someone else for a profit.

4. Collectibles and Non-Fungible Tokens (NFTs): Markets for collectibles or NFTs can also exhibit characteristics of the Greater Fool theory. The value of these items can be highly subjective and driven by speculation, leading investors to purchase them with the hope of selling them to someone else who values them more highly.

5. Penny Stocks and Highly Speculative Investments: These are often targeted by investors hoping to quickly flip them for sizable profits. The liquidity and information asymmetry in these markets can sometimes allow for significant gains based on selling to those who are less informed or more optimistic about future prospects.

It’s crucial to understand that the greater fool theory inherently suggests a level of risk, as it relies on the assumption that there will always be someone else willing to pay a higher price. When the pool of willing buyers dries up, the last holders of the asset can encounter significant losses, as the asset’s price corrects to reflect its intrinsic value or market conditions change. Which brings us to…

What are the risks of the greater fool theory? 

Perhaps the biggest risk of the greater fool theory is buying an asset for a foolish price, just before the asset’s price declines. Going back to the technology example above, it would be like buying a new smartphone for $1,000, only to see the same phone listed for $449.99 six months later. 

Losing money is one risk, but so is buying assets without evaluating their true worth. Ignoring valuation metrics under the assumption that another investor will come along and buy the asset from you is a bit like foregoing the inspection on a used car: without at least examining the engine, you could buy a car with expensive problems. Unless you can also find a buyer who will forego the inspection, you could then be stuck with a lemon. 

Should you use the greater fool theory to invest? 

The greater fool theory is a risky short-term investing strategy, and it’s not the best way to build wealth over the long run. 

For one, hype around stocks is never sustainable. At a certain point, the bubble will burst, and investors will wake up to a stock’s true value. You might get lucky and sell your overvalued stocks before this happens. But that’s not for you to decide. If you misread the market, or if investors begin demanding lower prices for a stock, you could become the greatest fool. 

In many ways, the greater fool theory can be reduced to a game of duck-duck-goose, in which the investor who owns the asset last (before its price falls) is the greatest fool of all. 

In the short term, popular sentiment might play a big role in pricing a stock. But over the long term, a stock’s true value will emerge: fundamental factors, such as cash flow, revenues, leadership, business model, liabilities, and earnings, will determine how a stock performs on the market. While you can make money as a greater fool investor in the short term, you’ll likely earn more over the long run if you pay attention to these fundamentals. 

The “greater fool” game refers to a situation where someone buys an asset (such as stocks, real estate, or collectibles) not because they believe it has intrinsic value, but because they expect someone else to buy it from them at a higher price. In other words, they are betting that there will always be a “greater fool” willing to pay more, even if the asset itself is overvalued.

Identifying the greater fool game: Key signs to watch for

To recognize someone who wants to play the greater fool game, look for these signs:

1. Focus on Price, Not Value

They might talk about how an asset is “worth” a lot because of recent price increases, rather than the underlying value of the asset itself. Their primary concern is the expectation that someone will pay more, not whether the asset is actually worth what they’re paying for it.

2. Belief in “Riding the Wave”

They often talk about the asset as a “hot trend” or a “bubble” that’s going to keep growing. They are motivated by FOMO (fear of missing out) and believe that prices will continue rising, regardless of the asset’s actual value.

3. Short-Term Focus

They are usually not interested in holding the asset long-term or its fundamentals. Instead, their strategy revolves around buying low and selling high in the short run, without any concern for the asset’s long-term prospects.

4. Dismissal of Risk

They often downplay or ignore risks, convincing themselves that the price will always rise, or they justify the high price by claiming it’s an “exceptional opportunity.” They might even say things like, “It’s different this time” when asked about the risks.

5. Following the Herd

Greater fool players are often highly influenced by trends and public opinion, following what the majority is doing, and they rarely question whether the asset is fundamentally sound.

6. Excuses When Prices Drop

When the asset’s value starts to drop, they might make excuses, saying it’s a temporary dip or blaming external factors. They will still hold onto the asset in hopes that someone else will buy it at a higher price, even as they begin to lose confidence in the actual value.

7. Unwillingness to Consider Long-Term Consequences

They are less concerned with the consequences of overpaying or the possibility of losing money. Their main focus is on finding someone else who will take the asset off their hands for a profit.

In essence, anyone who displays behavior based on speculation rather than solid financial reasoning or long-term value considerations may be playing the greater fool game. It’s more about the belief in an ever-increasing price trend than the actual merit of the asset itself.

Real life examples of the greater good theory

Here are some historical events where this theory played out – with lessons:

The Housing Bubble (2008)

• Lesson: Real estate prices soared as investors believed they could always sell properties at a profit, underestimating the risk of declining prices and over-leveraging.
• Takeaway: Understand the true value and risks associated with leverage. Diversification and risk management are critical in avoiding catastrophic financial loss.

The Dot-Com Bubble (1995)

• Lesson: Overenthusiasm and speculation can drive asset prices sky-high without fundamental support. During this period, investors poured money into internet stocks, often ignoring realistic valuations or potential profitability.
• Takeaway: Always evaluate a company’s fundamentals before investing. Excitement and trends shouldn’t overshadow practical valuations and business models.

The Florida Real Estate Craze (1920s)

• Lesson: Land prices skyrocketed in Florida as speculative investors rushed in, until the bubble burst due to hurricanes and fraudulent practices being uncovered.
• Takeaway: Perform thorough due diligence. Market euphoria can blind investors to underlying issues, including fraud and environmental risks.

Tulip Mania (1630s)

• Lesson: At the peak of Tulip Mania in the Netherlands, single tulip bulbs sold for extraordinarily high prices, fueled by speculative trading.
• Takeaway: Speculative bubbles are rarely sustainable. Recognize signs of unsustainable growth, such as when asset prices significantly surpass intrinsic value. Tulip Mania is now used as a metaphor symbolizing irrational market speculation, where hype and greed drive unsustainable price inflation, ultimately leading to a devastating crash.

The 2025 Los Angeles Wildfires?? (Speculative!)

In January 2025, devastating wildfires swept through Los Angeles, destroying over 16,000 buildings in neighborhoods like Altadena and Pacific Palisades. In the aftermath, investors rushed to acquire burnt-out plots at discounted prices, anticipating quick profits from rebuilding efforts. Could this be the next example??

• Lesson: Speculative investments in disaster-stricken real estate can lead to financial pitfalls if underlying risks and market conditions are not thoroughly assessed.
• Takeaway: Before investing in distressed assets, conduct comprehensive due diligence, considering factors such as environmental risks, insurance costs, and long-term market stability to avoid becoming the “greater fool” in speculative ventures.