What Is the Greater Fool Theory in Investing and Does It Apply to Crypto?

Without her knowing, this investment strategy is predicated on the greater fool theory, the idea that investors can make money buying an asset while completely disregarding fundamentals, simply because someone else will be willing to buy it at a higher price.

Let’s dive into the theory, some examples, whether it applies to crypto, and how to avoid being the greater fool yourself!

What Is the Greater Fool Theory?

With the greater fool theory, investors not only ignore overvalued levels, they completely disregard valuations, earnings reports, intrinsic value, or any fundamentals for that matter. It is merely based on the thesis of “someone else will pay more.” This theory works in principle, but when the market runs out of greater fools, the last colloquial fool will be left holding the bag.

In financial markets, the theory becomes incredibly relevant after an extended period of upside. After such a period, the rally becomes driven by the anticipation of further upside and the emotions of euphoria and greed, rather than fundamentals. In these cases, the greater fool theory suggests that buying can always be justified.

Examples of the Greater Fool Theory

Essentially, the greater fool theory becomes relevant during speculative bubbles. With more and more people hoping to make a profit, it usually does not take long before a market bubble forms – and eventually bursts.

Let’s look at a few examples of the greater fool theory in practice.

Dot-Com Bubble

In the late 1990s, global excitement about the then-new internet technology pushed American technology stock prices through the roof. At the end of the century, both retail and professional investors flocked to technology stocks to get rich quick, buying into stocks like pets.com, boo.com, WorldCom and Microsoft at unprecedented rates. This buying frenzy caused the U.S. Nasdaq index to rise from just $1,000 to more than $5,000 in just under 5 years.

Eventually, the hype died down, the influx of new money dried up, and no greater fools were left to buy – resulting in a market sell-off. Many of the stocks that Wall Street loved before the market crashed, eventually went under. Out of the examples we mentioned, only Bill Gates’ Microsoft made it out alive.

Housing Market Bubble

Another famous example of the greater fool theory in action; the financial crisis of 2008. More specifically, the cause of the global crisis. In the years leading up to 2008, the American housing market went through a tough time. Homeownership peaked in 2004, after which home prices started to fall, and the number of new homes constructed dropped rapidly.

Mortgage-backed securities are claims to the cash flow generated by large pools of mortgages, most commonly the income of residential real estate.

When interest rates increased, borrowers were no longer able to pay their mortgage obligations, resulting in mass defaults on their loans, and most mortgage-backed securities losing close to all their value. Because hedge funds, banks and private investors had invested more than a trillion dollars in these MSBs, it did not take long for these losses to spill over into the stock market, and a global financial crisis ensued.

In this case, an unhealthy housing market with inflated valuations was the problem, but it was greater fool investing that caused the global economy to crash down like a house of cards.

2021 IPO Craze

After the 2020 Covid pandemic hit, central banks across the world launched large-scale programmes aimed at injecting liquidity into economies. With low-interest rates, the stock market rapidly rose higher – and privately held companies wanted to take advantage. As a result, there were 1035 IPOs in 2021 alone – many of which were listed far above their fundamental value.

Nevertheless, social media and stimulus checks fueled another market bubble, where many new investors entered the market – pushing valuations to all-time highs. Eventually, the real-world economic situation caught up to the market, and the whole thing came crashing down once again.

The moral of these stories is that when the greater fool approach becomes a popular investment strategy, a market bubble is usually right around the corner.

What Are Market Bubbles?

Crypto and the Greater Fool Theory

Source: https://coinmarketcap.com/charts/

Is Crypto Based On The Greater Fool Theory?

Essentially, when economists refer to the greater fool theory at the heights of a cryptocurrency bull market, they are probably correct. Conversely, when they do so when the market is trending lower, these greater fool investors are mostly out of the market – being replaced by investors with more sophisticated motivations for buying into the market. Nevertheless, there certainly are tokens and NFTs in the market that are predicated purely on greater fool investing – with little to no intrinsic value or utility to drive upside.

Should You Ever Try To Use the Greater Fool Strategy?

All things considered, the Greater Fool Theory is a very risky investment strategy that is not recommended for long-term use. Nevertheless, with proper risk management and a bit of preparation it can help generate significant profits – especially in the early stages of a bull market. Be wary once greater fool investing starts to become the popular investment strategy among the general public – this is usually a sign that time is running out.

How To Avoid Being the Greater Fool?

During speculative bubbles, it makes sense to be wary of the sell-off that will inevitably follow. Especially if you have been on the wrong end of one of those sell-offs before, emotions will likely run high when the market soars as hard as it can during crypto bull markets.

Whenever it feels like the market is irrationally high, chances are you are buying into overvalued assets. This does not have to be a problem, but it is important to be cognizant of it. Let’s dive into a couple tips to help you avoid becoming the greater fool.

Financial Markets Are Unpredictable

For the most part, financial markets are hard to predict. Keep this in your mind as you trade – especially how it is nearly impossible to know when the hype-fuelled rallies come to an end.

Diversify Your Portfolio

Diversification is one of the best ways to protect yourself against any risk, even the risk of becoming the greater fool. If your portfolio is well-diversified across markets, the effect of becoming the greater fool is not as detrimental as it would be when you would go all in on that one bet.

Build a solid foundation of investments and use a limited amount of capital to chase greater fool investment plays.

Have a Long-Term Mindset

Most greater fool investment theses are built on the expectation of gains in the short term, sometimes even less than a day. When an investor plays the longer term, they care less about short-term fluctuations in price. In fact, a long-term investor might view such a buying frenzy as a great opportunity to sell some of his positions, and to buy it back after prices come back down.

Don’t Blindly Follow the Crowd

This goes without saying, but investments should be made at your own discretion, not by blindly following the crowd, or someone on Reddit or Twitter. If you make your own decisions, you can perform adequate due diligence, which will help pick out the right long-term investments.

Closing Thoughts

All in all, the greater fool investment strategy is a risky approach to trading that usually gains popularity in the heights of a bull market. Historically, hype-driven rallies have resulted in sharp corrections, suggesting greater fool investing does more harm than good.

When it comes to crypto, the greater fool theory applies as well – especially during an altcoin season or NFT mania, but less so during a crypto winter. It is recommended to make trading decisions based on a careful analysis rather than strategies such as the greater fools theory.

Writer’s Disclaimer: This article is based on my limited knowledge and experience. It has been written for educational purposes. It should not be construed as advice in any shape or form. Please do your own research.