Greater Fool Theory – How Does It Really Work?

The greater fool theory originates from the field of finance and tries to model crowd psychology around overvalued assets. While this might sound abstract and uninteresting, this theory finds applications beyond just conventional finance.

In any active market scenario, the phenomenon that the greater fool theory tries to model manifests itself. Being aware of this phenomenon and its usual signs would help you avoid falling into potential market traps.

In this essay, we start by covering what exactly the greater fool theory is. Following this, we look at a couple of relatable real-world examples of its application. Finally, we look into ways of benefitting from this knowledge and avoid market traps. Let us begin.

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What is Greater Fool Theory?

At its core, the greater fool theory describes a simple market phenomenon:

In any arbitrary market, there often exists a “fool” who pays for an overvalued asset just in hopes of selling it to an even “greater fool” for a profit.

In theory, there are only two possibilities here: either the “greater fool” exists or the “greater fool” does not exist. In practice, however, this kind of behaviour often triggers a herd-mentality from the market crowd.

People start buying just because others seem to be buying. Fear of missing out (FOMO) kicks in, and the price of the asset gets desynchronized from its utility (known as intrinsic value in the biz). As you can imagine, this cannot go on forever.

The whole scenario turns into a grandiose round of musical chairs. As the music blasts the loudest, the price climbs up the fastest; this is often described in the biz as a “bubble”. When the music stops, the “greatest” fool is left with an asset that is rapidly depreciating in value (a “bag-holder” in financial slang). The “greatest” fool is then bound to make a loss on his/her speculation.

On the other hand, as long as a “fool” is able to avoid being the “greatest” fool, he/she is likely to make a profit (by selling to a “greater” fool). This is why the speculative proposition looks so attractive to many market players.

Now that we have covered the theoretical part, let us look at a couple of relatable examples.

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Fun and Games

In late 2020, Sony launched its Playstation 5 videogame console and Microsoft released its Xbox Series X and Series S videogame consoles. The top tier versions of these products retailed at around $499 (US).

However, at the same time, due a variety of factors, a global semiconductor chip shortage was rampant (to a certain extent, it still is at the time of writing this essay). What this meant was that Sony and Microsoft could not keep up their console production with the demand from avid gamers.

The videogame console market arbitrageurs and scalpers duly noted an opportunity here and set to work. They bought these consoles in bulk at the retail price and then listed them on third-party resale markets (like ebay, for instance) for significantly inflated prices.

I remember seeing these consoles on sale for well over $1000 (US) at one point. Everyone knew that these consoles were not intrinsically worth that much money. However, these “foolish” sellers speculated on two hypotheses:

1. The chip shortage would continue to last for a while, and consequently, the supply-demand-gap would continue to hold.

2. There would be “greater fools” who are impatient enough to wait for a good deal and cave into the inflated deal in favour of instant gratification.

In an alternate universe, either of these hypotheses could have been proven wrong. And the sellers would have had to sell their stocks at a loss. However, most of these “fools” had a good outing in the market.

Update post publishing:

As a couple of readers have pointed out in the comments section, this is not a strictly correct example of greater fool theory since most of the buyers of these consoles were not intending to sell it for an even greater price. Most of these buyers planned to own these consoles.

Cryptocurrencies and NFTs

When it comes to cryptocurrencies and NFTs, the developers and the HODL crowd firmly believe in the assets that they develop/own. To them, these assets are not overvalued.

However, top economists/scientists question the intrinsic value that these assets have to offer. Their argument is quite simple.

“If a digital asset is worth $x, does it solve a problem that is worth $x?”

The developers and HODLers argue that the value exists in the future and is “priced into” the current market. The economists and scientists are not convinced.

I’m in neither camp (undecided). However, there exists a third camp, which is a beautiful example of the greater fool theory: the MOON gang. These are market participants who have bought into a digital asset at some point, and are evangelizing their “investment” as “going to the moon” (a metaphor for the price skyrocketing).

The intrinsic assumption here is that there must be some “greater” fool who buys it when ALL of us reach the MOON together. I’ll let you work the rest of that logic out.

Greater Fool Theory in Multi-Level Marketing

It would not be fair to cover greater fool theory without touching multi-level marketing — one of its biggest applications. Most multi-level marketing products involve a pyramid-structure where the intrinsic value of the “product” is marked up in hopes that there would be a greater “fool” available to buy it from you in the future.

I am yet to come across a genuinely convincing use-case for this business model. On the other hand, I have seen plenty of scams that operate under this business model. Greater fool theory is one thing, but scams are an entirely different thing; scams are illegal, for starters.

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How to Benefit from Greater Fool Theory

In any arbitrary market, whenever you get the feeling that you might be overpaying for an asset/product, ask yourself the following questions:

1. Do you believe in the core value of the asset/product? If so, can you objectively calculate this core value and compare it to the current market price?

2. If you are trying to scalp/flip an asset/product, what is your hypothesis about a higher price in the future. Can you prove this hypothesis?

Apart from these questions, there are a couple of points that sound obvious on the surface. But I am willing to risk sounding superfluous to drive the points home:

1. Be vary of any market environment that operates with the term “MOON” and its variants. No asset can just keep increasing in price — be it cryptocurrencies or the housing market.

2. Be wary of multi-level marketing products/schemes. If possible, avoid them altogether.

The greater fool theory is more of an empirical phenomenon than a scientific fact. However, when we pay attention to the common signs in its manifestations, we arrive at scientifically verifiable market traps.

With this background knowledge and simple heuristics, you could easily avoid these traps!

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Disclaimer:

I’m again stating the obvious here. The contents of this essay are not financial advice. They are my views based on my own reasoning and life experiences. I am just a random person on the internet; I am not a qualified financial advisor of any sort. So, please do your own due diligence before you arrive at conclusions.

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Interesting comment from reader James post publishing:

A much more clear obvious example is the beanie baby bubble or the similar mania over cabbage patch kids in the 80s.

I think there’s a simple thought experiment that you can use to avoid these kinds of things: does the ‘investment’ thesis revolve around the asset acting like a normal good or a Veblen good? That is, does it become more attractive as an asset if the price goes up or when it goes down?

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Further reading that might interest you: How To Debunk Astrology Using The Barnum Effect? and How To Solve The Dartboard Paradox?

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