The Greater Fool Theory

Should not apply to value investors when the stock market crashes

The greater fool theory suggests that if you make a questionable stock purchase in what is perceived to be a rising market, there will always be a greater fool who will buy your stock at a higher price.

It is based on the premise that a stock is worth what somebody else will pay for it, rather than on the fundamentals of a particular stock.

Where the theory falls down is that you may become the greater fool and get stuck with the stock when the stock price plummets.

People tend not to blame themselves and rarely blame the 'lesser fool' who sold the stock to them in the first place, no doubt at a higher price than what they paid for it.

The tendency seems to be that the stock market gets the blame when investors are left holding overvalued stock in a falling market. Disillusionment with the asset class sets in and retreat from the stock market is the inevitable result.


Making Money Using the Greater Fool Theory

Some stock market players, consciously or unconsciously try to profit from this theory by buying questionable (overvalued) stock on the assumption that there will be a 'greater fool' available who they can sell the stock to when they want to offload it at a higher price.

Unfortunately, no one rings a bell at the top of the market. So stock market 'investors' who try to ride the upward momentum that can build up in bull markets are often left with overpriced stock when the next downturn inevitably occurs, ... and when it does, it usually happens quickly.

The usual reason for this is that it is very difficult to make a selling decision when overall market prices are rising and when you don't have the means (or will) to determine if a stock is overvalued.

Greed tends to rule, and you risk hanging in too long. The inevitable may then occur.

Momentum investing to some degree works on the greater fool theory by relying on market optimism rather than on stock fundamentals.

But don't get me wrong. Momentum investing is a valid way to make money in a rising market ... providing it keep rising!


Avoiding Being the Greater Fool

Rather than assuming that there will always be someone out there who is prepared to pay more than you did for your stock, carrying out a stock valuation exercise using one or more of the stock valuation methods available would seem to be a better alternative.

Calculating an estimate of the fair value of the stock would allow you to be aware when the stock is becoming overvalued. Precautionary part selling of your holding can then be undertaken.

Setting a trailing stop loss is an alternative or additional strategy you can invoke to lock in profits and provide insurance against a downturn.


To Conclude

Value investors, who make a practice of buying stock at less than its intrinsic value, and so establish a margin of safety, are less likely to become 'greater fools' as they rely less on market sentiment and more on the fundamentals of particular companies.

They are in a better position to judge that particular stocks are overvalued and are more likely to have sold or part sold their stock before the downturn occurs.

Will there be greater fools the next time the stock market overheats? You bet!

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