The Greater Fool Theory, also referred to as the inverted-U theory, is a simple but powerful principle of investing that states that when an investor is willing to risk losing everything, the best strategy is to put all one’s money into a stock. Suppose an investor believes that hunching overstock will produce the most profit for a prolonged period. It is better to risk losing everything than to refuse to participate in such a strategy and hope for the best. This theory can be abused. For example, some investors may believe that shorting a stock is the perfect trading strategy, even though it is risky. Moreover, some traders may see the theory as a license to trade, where putting all their money on one stock is merely a convention for them to follow. However, there are risks to using this theory that should be considered.
It is not always easy to find the next fool
In a market of rising prices, it is difficult to find stocks that are cheap enough to satisfy investors who buy them and eventually lose money. However, if the market is declining, it is not easy to find stocks whose prices will rise sufficiently so that investors can make future profits. This implies a period where investors should wait before buying or selling shares.
It is easy to forget that the future is not what it used to be
In the past, when an investor sold a stock at a high price, they were guaranteed to make profits. Unfortunately, this no longer holds in today’s market, where hindsight appears to make sense of the past while applying it as a lesson for us in the present and future. In reality, however, things change quickly over time such that even the fundamentals of stocks may not support their current prices compared with their value twenty years ago. This reality has far-reaching implications for those who try to use the concept of the “Greater Fool Theory.” Indeed, when the price of a stock rises, there may be fools who will buy it, but there may also be no fools’ insight.
The real world is not a zero-sum game
This theory assumes that stock investment is a zero-sum game: someone else will lose money if an investor makes money selling stocks. In reality, however, this situation does not always occur and depends on how many investors participate in the transaction. The more buyers and sellers there are in a market, the greater the sum of profits and losses. This is because they will balance each other out, which means that no one will make a profit or suffer a loss.
There are no guarantees in the business
Some investment strategies involve gambling that purports to guarantee investors gains from risk-free trades. Unfortunately, investing involves risks instead of outright gambling, where any transaction comes with some level of uncertainty in return for potential gain. The theory relies on the fact that even though money may be lost during a decline in the stock market, there will still be those who buy the stocks from investors who take part in sales at high prices. However, if there are not enough buyers for an investor’s stocks, despair would result.
The price of a stock may be greater than its intrinsic value
When a stock’s price rises, it reflects the desire of an investor to buy at a high price, not necessarily the true value of the stock. For example, assume that an investor paid $100 for a share of stock with a value of $100. This might be due to many factors, such as the company’s reputation in the market or its potential for future profits. However, suppose the same company experiences a rapid increase in its stock price without any pronounced improvement in its operations or technology. It is reasonable to assume that people are buying this stock based on other reasons and not on its real value as determined by market participants.
There are no hard-and-fast rules in the market
The theory may work for some investors, but it does not necessarily work for others. The reason is that different investors have different strategies for investment, including some who take advantage of this theory by buying stocks at high prices and selling them at a low price later on in the market. In addition, there are no hard and fast rules in the market to explain why a particular stock’s price rises or falls at certain times. Instead, it depends on many factors, such as how other investors respond to information about a company that is released repeatedly over time.
The theory does not apply to every company
It is widely accepted that this theory does not apply equally to all companies in the market due to differences among different industries and business structures. For instance, some industries are dominated by family-run firms in which ownership is passed from one generation to the next; this means that it becomes difficult for outsiders to buy shares of stock, except through an initial public offering (IPO) or mergers and acquisitions (M&A). On the other hand, more investors choose to buy stock directly from companies in some other industries instead of relying on this theory. Examples include technology stocks and commodity companies like oil and gold miners.
Investors must know when to get out
This theory calls for investors to sell their stocks after enjoying large profits in the market. Investors should not go overboard on this theory, though, as it is possible that the price of a stock may fall after they take their profits and put more money into another project that does not seem cheap enough for them. On the other hand, if an investor does not sell her stocks after a big profit from her previous investments, she risks being called a “fool” by others.
Conclusion
In conclusion, then, the Theory of the Greater Fool is a useful tool for investors to use, but its application must be made with an understanding of when not to use it. It is a fool’s game to assume that every investment will rise in value, especially when publicly traded stocks and companies.
Story by Hari Babu
Support AFP
Share
AFP
