THE GREATER FOOL THEORYBy MARY LYNNE DAHL , Certified Financial Planner ™
February 21, 2021
(SitNews) Ketchikan, Alaska - In Europe during the 17th century, Holland was the world’s leading economy with the highest per capita income in the world and it operated a formal investment market, similar to our own modern stock market. Assets bought and sold in this market included tulips, among other things. Tulips were valued as fashionable and elegant flowers for wealthy homeowners. They were expensive, so the price of the bulbs rose dramatically as the demand for them grew. During the mid-1600s, tulips became the subject of so much price speculation that the rarest bulbs sold for as much as six times the annual salary of an average Dutchman. This speculation in tulip prices became known as the “tulip mania”. This term is often used to describe an economic bubble of any investment that is selling at prices that are far above the actual value of the asset itself.
There is a feeling of déjà vu about this story of the Dutch tulip mania. Many scholars over the centuries since it was first reported have disagreed on why and how it happened, but there are several similarities between the then and now that are interesting. One is that the speculation in tulips was conducted primarily among wealthy merchants and skilled craftsmen in Holland, not the nobility. They were successful enough to have discretionary income, but they were not the extremely wealthy, ultra-rich. It happened during a plague, and was considered a “winter drinking game” for a plague-weary population looking for a way to liven up the dark days they were living through. Does all of this sound vaguely familiar?
Prices of assets generally reflect the intrinsic value of those assets. That intrinsic value is based on whether and how much profit the asset produces. At some point, if the price per share becomes too high, the stock is considered “overpriced” as to its (real) intrinsic value. When speculators enter the market, rising share prices can easily result from the appearance of greater demand for that asset, regardless of the underlying fundaments and real value. In a way, it is like a feeding frenzy among creatures who are not actually hungry. The problem with overpriced assets is that while they may not actually be worth their price, the frenzy to buy pushes the price up even further. This is made worse because there is a distinct difference between the price of a stock and the value of a stock that many people do not recognize. I often hear comments about “today the value of XYZ shares rose” What is meant is that “the price rose”, not the value. The value is fundamental but the price moves around all the time, up and down.
People who speculate in buying overpriced assets can actually create a demand for them, which illustrates what is referred to as the “Greater Fool Theory”. They believe that the asset/stock they are willing to pay an unwarranted high price for will continue to rise, allowing them to sell it to another “greater fool”. The theory is that there is always someone else who will pay a higher price than the previous owner paid. It has nothing to do with intrinsic value or underlying fundaments such as earnings or cash flow. It is fueled entirely by speculation, which depends entirely on the emotions of fear and greed. If this was how markets should normally work, the price of stock would always rise and never go down. However, we know this is not what happens in the real world, however.
This was clearly demonstrated recently with the speculation game being played with GameStop options. The game was simple; a group of people acting as a block of option buyers drove up the price of the stock of GameStop, a functionally worthless company that has never even made a profit. By continuously buying shares and selling to a greater fool than themselves, they managed, for a short period of time, to engage other greater fools to bet against the option that the stock price would go down, thereby creating so much demand for the stock that it rose to ridiculous levels. The game did not end well and a lot of people who played were left with a lot of worthless paper when the price did drop. GameStop shares started with a price of about $13.00 and got as high as about $ 483.00 per share before dropping back down to about $49.00 per share. Many shares had already been sold, multiple times, at prices in the hundreds, and most of those buyers lost money. It was a hard lesson for a lot of people who were playing a game of speculation, not investing. Real investing involves buying and selling shares at fundamentally sound prices much more in line with the actual intrinsic value of those shares, not as a betting game. Stock investors look for and buy shares of real value. They do not bet, gamble or consider investing a game. They generally tend to hold their shares for decades, not days and certainly not for merely hours. Savvy investors look for value, not price. They look for companies, funds and products that produce income and value.
The value of a company is based on the fundamentals of how well it is managed, how much profit it earns after expenses, how reliable it produces products and cash flow from normal operations and how steady it grows those revenues and controls those expenses. These are basic fundamentals that are a good measure of the value of a company. Share prices generally reflect that value, despite market fluctuations and the occasional overpricing that occurs. Creating wealth for any investor relies on recognizing value and accumulating enough shares to rely on for income or gain in the future, regardless of when the future arrives. Speculating, on the other hand, has blocked more opportunities to create true wealth as a result of people who have succumbed to the “greater fool theory”. It rarely helps and it usually destroys wealth. It is fast and risky, rather than slow and steady. It usually ends by correcting itself back to normal, but unfortunately, also after a lot of money has been lost by those who were fooled into playing the game.
Don’t be “the greater fool” in a game that few ever win. Investing is an art and a science, not a game. Safeguard your investments by taking your time, sticking with a disciplined plan to gradually and carefully accumulate the assets that you reasonably believe will provide you with the lifestyle and security you are seeking. It may sound boring, but it’s a lot more fun to get rich slowly than to play a loser’s game and end up as “the greater fool”.
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