Tuesday, September 11, 2007

Greater Fool Theory

From Investopedia.com

A theory that states it is possible to make money by buying securities, whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who is willing to pay the higher price.

When acting in accordance with the greater fool theory, an investor buys questionable securities without any regard to their quality, but with the hope of quickly selling them off to another investor (the greater fool), who might also be hoping to flip it quickly. Unfortunately, speculative bubbles always burst eventually, leading to a rapid depreciation in share price due to the selloff.

From Wikipedia:

The bigger fool theory or greater fool theory (also called Survivor Investing) is the belief held by one who makes a questionable investment, with the assumption that they will be able to sell it later to "a bigger fool"; in other words, buying something not because you believe that it is worth the price, but rather because you believe that you will be able to sell it to some one else for an even higher price.

It might be on some occasions a valid method of making money in the stock market -- however, the market participants eventually realize that the price level is too outrageous and the speculative bubble pops. The bigger fool theory relies on market optimism concerning a particular stock, an industry, or the market as a whole.

The opposite of the bigger fool theory is value investing, which tries to discount market psychology. Value investors such as Warren Buffett believe that it is corporate profits which are the normal returns from stock investments, and any higher return is only possible due to the bigger fool theory.

The bigger fool theory holds for any pure value transaction, not just speculative ones. When a commodity with a universal value is traded then, no matter how the situation is interpreted, either the seller or the buyer has made a mistake.

However, the majority of transactions are not pure value transactions: the value (or utility) that a given product has is dependent on a wide variety of factors, which will often be very different between the buyer and the seller.

For instance, in a bartering economy, there might be a tomato farmer living next to a cherry farmer. The tomato farmer has a large supply of tomatoes, and very little demand, so for him tomatoes have very little value; but he has a small supply of cherries and a higher demand, so for him they are much more valuable. The situation is reversed for the cherry farmer, so a trade of tomatoes for cherries would be a profitable transaction for both parties.


Paly said...

Here is another quote from Robert Shiller's HISTORIC TURNING POINTS IN REAL ESTATE:

"Analysis of past booms seems to indicate that investors in both the stock market and the housing market seem often not to understand the supply response to price increases. These are normal intelligent people, why would they repeatedly make the same mistake again and again? There seems to be what I will call a uniqueness bias, a tendency for investors to overestimate how unique an investment they favor is, failing to take account of the inevitable supply response to high prices. The uniqueness bias is reflected in quite a number of anomalies of human judgment that psychologists have documented, including the “representativeness heuristic,” “overconfidence,” “wishful-thinking bias,”
“spotlight effect” and “self-esteem bias.”

mohican said...

I loved reading that study a couple months ago because it quite succinctly puts our market into perspective.

The uniqueness bias at work in Vancouver.

freako said...

The thing about greater fool games is that it is a zero sum game (actually negative once we include misallocations). Surprisingly, many people willingly play the game with realizing this zero sum aspect. And by definition, everyone entering the game think that they are smarter than the next guy. The other thing to note is the speed at which these things can unravel.