Understanding the Greater Fool Theory: Market Valuation & Irrational Exuberance

The Greater Fool Theory simply states that there will always be a “greater fool” in the market who will be ready to pay a price based on higher valuationValuation MethodsWhen valuing a company as a going concern there are three main valuation methods used: DCF analysis, comparable companies, and precedent transactions for an already overvalued security.

Markets are affected by a lot of irrational beliefs and expectations of market participants. Based on that premise, the greater fool theory states that there will always be an investor, i.e. a “greater fool”, who will foolishly pay a higher price than the intrinsic worth of a security.

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Greater Fool Theory Investing

The greater fool theory can be used to design an investing strategy based on the belief that you will always be able to sell a security or asset at a higher price to a “greater fool” who will pay a price based on unjustified multiplesTypes of Valuation MultiplesThere are many types of valuation multiples used in financial analysis. They can be categorized as equity multiples and enterprise value multiples. for a security or other asset. Basically, the idea is that you can make money by speculating on future price increases because there’s always a greater fool willing to pay more than what you paid, even if you paid too much based on the investment’s intrinsic valueIntrinsic ValueThe intrinsic value of a business (or any investment security) is the present value of all expected future cash flows, discounted at the appropriate discount rate. Unlike relative forms of valuation that look at comparable companies, intrinsic valuation looks only at the inherent value of a business on its own.. Greater fool investing relies on the assumption that someone else will be left stuck with an investment when the speculative bubble finally bursts, as people begin to realize the price attached to an investment is just unrealistically high. The key to successful greater fool investing is just making sure that the greater fool isn’t you.

The greater fool theory approach to investing, instead of focusing on trying to accurately discern the true, or intrinsic, value of an investment, focuses on simply trying to determine the likelihood that you can sell the investment to someone else for a higher price than what you paid.

Essentially, the greater fool theory in investing is a type of Game Theory that speculates about what other investors will be willing to pay for a security. It’s kind of the opposite of looking at only the intrinsic value of an investment.

The Financial Crisis as an Example of the Greater Fool Theory

Valuations based on highly inflated multiples cannot continue indefinitely. The bubbles formed by these irrational valuations are bound to burst and that is when a crisis arises. Take the case of the subprime mortgage crisis, where people took credit from banks in order to buy houses, hoping to find a greater fool in the future to whom they could sell the house at a higher price and make substantial gains.

That worked for many years as there seemed to be an endless supply of greater fools. But eventually, the supply of fools began to dry up as more and more people began to see the reality that, “That house isn’t worth that much – it’s overpriced.” Suddenly, the sellers, i.e., the mortgage takers, could not find buyers and the banks needed to write a huge amount of credit lent to these mortgage takers off their balance sheet. This contributed to a nationwide banking emergency and eventually led to the worst recession seen in decades.

The purpose the greater fool theory serves is not really to provide investors with a trading strategy based on finding fools, but more just to help explain how speculative bubbles may form.

How to Avoid Being a “Greater Fool”

• Do not blindly follow the herd, paying higher and higher prices for something without any good reason.
• Do your research and follow a plan.
• Adopt a long-term strategy for investments to avoid bubbles.
• Diversify your portfolio.Capital Allocation Line (CAL) and Optimal PortfolioStep by step guide to constructing the portfolio frontier and capital allocation line (CAL). The Capital Allocation Line (CAL) is a line that graphically depicts the risk-and-reward profile of risky assets, and can be used to find the optimal portfolio.
• Control your greed and resist the temptation to try to make big money within a short period of time.
• Understand that there is no sure thing in the market, not even continual price inflation.

To learn more, launch the CFI behavioral finance course to avoid common pitfalls.

Other related terms

• Valuation methodsValuation MethodsWhen valuing a company as a going concern there are three main valuation methods used: DCF analysis, comparable companies, and precedent transactions
• Price-to-earnings ratioPrice Earnings RatioThe Price Earnings Ratio (P/E Ratio is the relationship between a company’s stock price and earnings per share. It provides a better sense of the value of a company.
• Multiples analysisMultiples AnalysisThe multiples analysis is a valuation technique that utilizes different financial metrics from comparable companies to value a target company.
• How to read stock chartsHow to Read Stock ChartsIf you’re going to actively trade stocks as a stock market investor, then you need to know how to read stock charts. Even traders who primarily use fundamental analysis to select stocks to invest in still often use technical analysis of stock price movement to determine specific buy and sell, stock charting