What Does Greater Fool Theory Mean?
A theory that states it is possible to make money by buying securities, whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who is willing to pay the higher price.
Investopedia explains Greater Fool Theory
When acting in accordance with the greater fool theory, an investor buys questionable securities without any regard to their quality, but with the hope of quickly selling them off to another investor (the greater fool), who might also be hoping to flip them quickly. Unfortunately, speculative bubbles always burst eventually, leading to a rapid depreciation in share price due to the selloff.
Thus, stocks and properties that are extremely overvalued will see their value decline much faster than those that are not. This could lead to substantial trouble for the investor, who was depending on the greater fool theory to save him or her from a series of bad investments. Once the market bubble bursts, there is no security, and the potential for catastrophic loss becomes very real. This is often referred to as a "correction."
A single investor, or even a small minority of investors, acting upon the greater fool theory is not a big deal for the economy. Any single investor, no matter how large, would have a difficult time influencing the market. There is simply too much money in the system for an investor to think his or her losses will matter in the overall picture.
The problem arises when many investors decide to buy into the greater fool theory at the same time. In order for the theory to truly work, even for a short period of time, this is what must take place. These investors, collectively investing in junk stocks, can all experience substantial losses. This could be enough to cause some to rethink their purchasing strategy, which in the long run could be a good thing. In the short run, however, it could be disastrous, causing a slowdown of buying, and a market crash.
While the greater fool theory has the potential to make a person very rich, paying more for something than it is worth is always risky. Eventually, someone must be left holding the worthless piece of property. Regularly relying on theory means there is the potential for the gamble to catch up with any investor. Avoiding such a loss would take a substantial amount of luck over the long haul.
