One of the more famous and oft-quoted axioms of investing is that the greater the foolishness of an investment, the more reliable it will be in the long run. While this may be true in some cases, it is not necessarily the case for all investors. How much do you know about the greater fool theory? And how can you take advantage of it? Let’s look at the theory and see why it may be reliable to apply to your investments.
Definition
The greater-fool theory (GF) is a particular investment strategy. It advocates investing in situations where you expect there only to be one or two investors in the situation. In its most basic form, you sell security above its current price and buy it below it. In other words, you’re “buying high and selling low.” The theory states that this is since you can only sell to one or two investors at a time. So, if there are five parties in the security, three of those people are likely to ignore your advice. Thus, you waste your time.
How it’s Used
The theory often explains a large number of investment bubbles. It was especially prevalent during the dot-com bubble of 1999. The greater fool theory is often thought of as one of the primary reasons the bubble ever occurred. This strategy is that you can essentially sell a security that has no intrinsic value above its value at purchase. This means the security is worth more if sold off to an investor willing to purchase it at a price larger than its current value. This is often the case with stocks not expected to perform well. Or, stocks that do not have an intrinsic value. In other words, it is a way of buying low and selling high while also taking advantage of another investor’s ignorance.
Who Benefits
This strategy is most useful for those looking to purchase a security at a lower price than its current market value. But to do so, they need someone else to pick their purchase at a higher price than they paid. It is often risky since the investor needs to take a larger risk. They also have to attempt to take advantage of a less knowledgeable investor. This is someone who likely isn’t going to sell at the higher price. This may cause problems if one of the investors doesn’t act quickly. Or, if they are unable to meet the terms of the sale. It is also difficult for investors because they need to trust someone else will make good on their promise. You must rely on the fact that this person has a large amount of money sitting around for such purchases.
Why it Doesn’t Always Work
There are a few reasons why this strategy does not always lead to positive results for an investor. The first is that there is usually a trade-off between size and speed. The more investors you are attempting to sell to, the larger your investment will have to be, and vice versa. An investor should opt for a larger size to quickly increase their chances of selling. Still, it can also take longer if there is an over-abundance of investors interested in purchasing the securities. A second major issue with this strategy is that many investors interested in purchasing the security do not necessarily indicate that it will be worth more than its current price. It can often mean that the stock will decline even further or cease trading entirely.
Key Takeaways
The theory may seem like a peculiar strategy that is useful in a limited number of situations. However, there are times when it is essential to know when and how to use this strategy. The important thing about this strategy is that you need to use it for situational purposes and not for every investor. The only way you can benefit from the theory is by doing so with an investment that has an intrinsic value or has yet to experience a significant rally.
How this Applies to You
The greater fool theory is extremely difficult to use, but it can also be useful in certain situations. The important thing about understanding this concept is that you need to have a very good grasp of the current market price. You need to be able to evaluate the potential upside of purchasing the security at a lower price than its market value. This also requires that you invest a significant amount of money in taking advantage of this strategy, so it may not be an option for those who only want to purchase small amounts of securities.
What it Means for You
The theory is a useful strategy in certain situations, but it doesn’t apply to every financial situation. To take advantage of this strategy, you need to understand the current market value and evaluate the potential upside and downside of purchasing that security at a lower price than its current market value. You also need to be willing and able to purchase a significant amount of securities to take advantage of this strategy, so it may not be an option for those who want small investments.
Conclusion
The greater-fool theory is an important strategy for those looking to make a profit, but it does not apply to every investment. It is useful for those who have a good grasp on the current market value of a security, and it can also be used when you are willing to take on a large investment or risk. The strategy remains risky because you need to trust other investors will sell at your price.
