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The greater fool theory is an investment belief that explains why certain investors buy things like real estate, stocks, or artwork that seem to be overpriced. Even if the investment isn’t worth the asking price — and in many cases it isn’t — the theory teaches that, sooner or later, a “greater fool” will come along and wish to purchase it for an even higher price, thus earning the original investor a profit. It holds true most often during strong economic times and in markets that are saturated with buyers. Things can be harder in downturns or during market slumps; in these cases, it can take a very long time for that bigger fool to appear. When the waiting is too much, there’s a real possibility for loss, and most economic experts don’t recommend that people put too much faith in the theory unless they’ve done a lot of independent market research upfront. There can also be larger economic implications if a lot of investors buy into the theory at once in a market that’s on the decline. When there aren’t enough willing buyers, this sort of speculative investing can lead to bubble bursts and swift market crashes.
In times of an economic "bubble," the greater fool theory does seem to work. One of the defining characteristics of a bubble is that it creates artificial value, most often around stock or real estate. As long as investors are in a purchasing frenzy, they are often willing to overpay — and overpayment in some cases becomes the market standard and the “new normal.” People often buy things and then look to “flip” them or re-sell them somewhat rapidly in these situations.
Bubbles and inflated markets don’t last forever. Stocks and tangible properties that are extremely overvalued will almost inevitably see their values decline rapidly when this happens. This often leads to substantial trouble for investors who were depending on a greater fool in order to turn a profit. People in these situations often sell their property at a serious loss, made more acute if the price they themselves paid was overvalued. In most cases, 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 market "correction."
A single investor, or even a small minority of investors, acting upon the greater fool theory does not usually cause any sort of economic ripple. It is usually very difficult for individual investments, no matter how large they are, to influence the market. There is simply too much money in the system for individual losses or gains to matter in the overall picture.
Things tend to get more problematic when the theory starts becoming a prevailing belief. When many investors decide to buy into this theory at the same time they can sometimes actually create their own bubbles and, ultimately, their own crashes, most of which impact pretty much everyone. When investors who have collectively invested in something like junk stocks, overpriced real estate, or artwork of questionable value all experience losses at the same time, this could be enough to cause some new investors to rethink their purchasing strategy. There is an argument to be made that this could be a good thing in the long run. In the short term, however, it can be disastrous, causing a slowdown of buying and in extreme cases possibly also 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. At some point, someone will be left holding the overvalued piece of property. Regularly relying on the theory means there is the potential for the gamble to catch up with any investor. Avoiding loss would take a substantial amount of luck over the long haul, as well as a lot of insight into what the market is likely to do in the future.
What is puzzling is when people start to view a bubble market as a normal one. Those are the folks who talk about how markets have changed, etc.
The truth is this -- markets don't change. The same rules always apply. Someone will be left holding the bag after a bubble. The trick is to make sure it's not you.