The greater fool theory is the belief that buying a security, or real estate parcel, at an unreasonably high price should still be able to return a profit, even though it may be overvalued. The reason this may work is because there will always be someone willing to buy the stock for more than the first investor paid for it. Thus, there is always a bigger "fool," even if the value for the item is not truly there.
In times of an economic "bubble," the greater fool theory does seem to work just as stated. Bubbles create artificial value, and usually happen around stock or real estate. As long as investors are in a purchasing frenzy, they are willing to overpay for a security, or piece of property. Thus, as long as the sale occurs when that frenzied buying is taking place, the theory works as stated.
Eventually, however, all bubbles must burst, since they are by definition abnormal. 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 this 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.