The greater fool theory states that it is possible to make money by buying securities (e.g. a company’s stock), whether or not they are overvalued, by selling them for a profit at a later date. This is because there will always be someone (i.e. a bigger or greater fool) who is willing to pay a higher price.
If acting in accordance with the greater fool theory, an investor will purchase questionably priced securities without any regard to their quality. If the theory holds, the investor will still be able to quickly sell them off to another “greater fool,” who could also be hoping to flip them quickly. 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.
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, instead of focusing on trying to accurately discern the true, or intrinsic, value of an investment. It plays off of the behavioral approach to economics, assuming that markets are affected by a lot of irrational beliefs and expectations of market participants and thus runs contrary to the Efficient Market Hypothesis and its assumption of a perfectly rational homo oeconomicus.
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, “This 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.