Greater Fool Theory Defined: How to Avoid Being a Greater Fool

The greater fool theory states “fools” who buy overvalued securities and assets will sometimes be able to find “greater fools” to sell them to at an even higher price before a speculative bubble bursts.

The theory applies to stock prices, real estate markets, and cryptocurrency exchanges. In all these scenarios, both “fools” and “greater fools” might still have a great degree of awareness about overvaluation but decide to take a risk anyway, while others might be ill-informed.

Proponents of the greater fool theory point out how market bubbles stretch on for a while before bursting, allowing at least a certain duration of time in which to sell and turn a profit. Critics insist putting the theory into practice is too risky, as you can never be completely sure when the bubble will burst, and you’ll become the “greater fool” yourself.

In practice, the greater fool theory follows certain steps. Follow along to learn how some “fools” turn a profit by selling to “greater fools.”

• Bubbles form. As investors become excited about a certain type of asset or security, market bubbles have the potential to form. A bubble forms when the fundamental value of a security or asset becomes overvalued and overpriced. For example, suppose a specific neighborhood has a particularly hot supply of available housing. People might begin to pay higher and higher prices to get into the neighborhood, eventually detaching the prices from what the values of the houses really are.
• “Fools” buy overvalued stocks. To deploy a “greater fool strategy,” certain investors act as “fools” of their own volition, buying overvalued assets on purpose. They know these valuations are out of step with reality, but they hope to time both their purchase and sell-by dates to get out of the market before the bubble bursts. This also enables them to sell to someone who’ll pay an even higher price than they did.
• “Greater fools” buy from “lesser fools”. After someone buys an overvalued asset, they might see its value climb even higher before it eventually crashes. At this point, they can sell to a “greater fool.” This person is willing to pay an even higher price than the first person did. The new buyer might be buying in the hopes of executing a greater fool strategy of their own.
• Markets crash. At some point, the forces of market volatility will make the bubble burst, reverting the price of the overvalued asset back to reality. This is what leaves the final person holding the asset the “greater fool,” as they lose a substantial amount of money on their purchase rather than turn a profit.

The greater fool theory has played out in reality a multitude of times. Here are just three prominent examples:

1. 1. The dot-com bubble: In the late 1990s, investors became irrationally exuberant about the vast majority of internet companies. While some would go on to become huge moneymakers, many more experienced overvaluation. As these companies traded on the stock market, certain investors deliberately bought and sold overvalued company shares to other “greater fools” before the dot-com bubble burst in the early 2000s.
2. 2. The financial crisis of 2008: One of the key takeaways from the 2008 financial crisis is how overvalued assets in one sector of the market can bring down the entire economy. Real estate prices became substantially overvalued at the same time bankers were selling overpriced bundles of subprime mortgage debt in financial markets on Wall Street. Eventually, the entire global financial system teetered on the brink of collapse as a result.
3. 3. The rise of Bitcoin: Crypto enthusiasts seem to operate with some degree of awareness of the greater fool theory' in mind. Bitcoin specifically has surged and plummeted in value multiple times since it came on the market. Before each mass sell-off and crash, “fools” buy the overvalued cryptocurrency to sell to “greater fools” who think it can only go up in value.

Putting the greater fool theory into practice can leave you holding the bag even if it sometimes leads to a high return, too. Consider these three steps to mitigate your risk in the market:

• Assess your appetite for risk. When you rely on the greater fool theory to make short-term gains in the market, you’re taking one of the riskier options available to grow your wealth. No one can say when the prices of specific assets—especially overvalued ones—will continue to climb or begin their collapse. Be sure you’re open to taking a riskier approach when employing this strategy. “Lesser fools” might become “greater fools” if they misjudge when to sell.
• Look for intrinsic value. Rather than buy overpriced assets, do your due diligence and seek out more solid intrinsic valuations for your purchases. Reach out to a trusted finance professional for advice about specific stocks. This approach is a lot more stable than buying and selling right against the edge of a market bubble bursting.
• Take a slower, steadier approach. There are many different types of investing strategies. You can make as much money (if not more) by taking a slow and steady approach as you would by taking a high-risk approach (i.e., by putting the greater fool theory into practice). Rather than try to beat market trends in the short term, consider investing long term in a diverse portfolio to mitigate risk.

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