Greater Fools’ Day: Don’t be the one holding the joke

Many would assume April Fools’ Day and the stock market have nothing in common, however, when it comes to the stock market, some investors may be playing a game of “who can be the greater fool?” And that’s where the Greater Fool Theory of investing comes into play, where investors buy overpriced assets hoping they can sell them later to someone else.

If you’re ready to take a closer look at this risky investment strategy, and perhaps learn how to avoid becoming the greatest fool of all, keep reading. In this article, we will explain the Greater Fool Theory and why it is used to explain some investors’ seemingly irrational behavior.

What is the Greater Fool Theory?

The Greater Fool Theory is an investing concept that argues prices on assets sometimes go up for no reason other than pure speculation and hype. As hype continues to grow, regardless of the asset’s true value, some investors may purchase the asset in hopes of selling it later to a "greater fool" at a higher price.

Is it possible to make money in a speculative, bubbly market? In theory, yes, you can. But if you know that the asset you are buying is rising in price because of market enthusiasm and not because of its fundamentals, yet you still pursue this strategy, you risk becoming the “greater fool” yourself.

Who wants to be a fool?

Some investments, such as some growth or even meme stocks, may derive their value from speculation and hype, rather than underlying fundamentals, such as earnings or revenue growth. As a result, the prices of these assets can be subject to significant volatility and may not always reflect their true underlying value.

In some cases, these speculative investments may experience significant price increases, and those price increases can last for what seems like a long time. For example, the U.S. housing bubble at the beginning of the 21st century lasted for roughly a decade, causing some homebuyers to think it was impossible for home prices to fall. They were willing to take on extra debt not thinking they would pay the high mortgage bill out of their income for 30 years but believing they could sell the house for a profit in five or 10 years.

Another example: The dotcom bubble of the late 20th century inflated because analysts and the media believed the invention of the internet had changed the rules of investing. Companies involved with the internet didn’t need profits or even revenue for their stock prices to rise. For more than five years, if you were investing in safer vehicles like value stocks, highly-rated bonds and cash deposits like certificates of deposit (CDs), you were losing money compared to those speculating on internet companies.

It’s important to note that not all speculative investments are valueless – however, with every investment, there is risk involved. Consider consulting your financial advisor before making any investment decisions.

Fools never studied law of gravity and economics

In the old Bugs Bunny cartoon “High Diving Hare,” Yosemite Sam ties up Bugs at the end of a high-dive board and saws it off, hoping to make Bugs fall. But instead, Sam and the high-dive platform go down, leaving Bugs standing on a plank in mid-air. Our hero turns to the camera and says, “I know this defies the law of gravity, but, you see, I never studied law.” Achieving the impossible and winning against all odds, logic or even the law of gravity, feels good.

It’s a common metaphor to say that the economy or the stock market must eventually bow to the laws of economics and gravity, but during asset bubbles some investors can get away with months or years of returns on hyped-up trending assets. However, it's a different story when the price of risky assets starts to drop just as quickly as it rose if market sentiment changes.

Investors who bought into the speculative asset thinking prices never go down or still had runway left are likely to feel the sting when it collapses, but arguably the “greater fool” in a bubble is one who knows that the assets they are buying are risky and of dubious fundamental value.

The Greater Fool Theory rears its ugly head when each bubble crashes, showing that market psychology can create fools out of even the most seasoned investors.

The bottom line

A lot of investing is a mix of looking at the fundamentals of an asset versus its price appreciation. But sometimes hype outweighs fundamental value. Don’t be fooled into investing in the latest hype just because everybody else is doing it. Look at the asset’s fundamentals and consult with your advisor. Remember, ultimately most bubbles burst.

View Disclosures