Greaterfooltheory

Understanding the Greater Fool Theory in Investing

Key Takeaways

The greater fool theory suggests that overvalued securities can be sold at a profit to someone willing to pay more, termed the "greater fool."
Ignoring fundamental valuations can lead to holding devalued securities when there are no more buyers.
Speculative bubbles and economic downturns expose the flaws in the greater fool strategy.
Conducting due diligence helps investors avoid being left with overpriced investments.
Bitcoin is often cited as an example of the greater fool theory due to its volatile price and debated intrinsic value.

What Is the Greater Fool Theory?

The 'Greater Fool Theory' in investing suggests that you can profit from buying overpriced securities by later selling them to someone else, a so-called 'greater fool,' at an even higher price. This investing concept dismisses traditional evaluation metrics like valuations or earnings reports. It implies that as long as someone more optimistic or less informed comes along, your investment can yield profits, though it carries significant risk if the market corrects. For investors, understanding this theory is crucial to avoid potential pitfalls and to know when due diligence is essential.

How the Greater Fool Theory Works in Investing

If acting in accordance with the greater fool theory, an investor will purchase questionably priced securities without any regard for their quality. If the theory holds, the investor will still be able to quickly sell them off to another “greater fool,” who could also be hoping to flip them quickly.

Unfortunately, speculative bubbles burst eventually, leading to a rapid depreciation in share prices. The greater fool theory breaks down in other circumstances, as well, including during economic recessions and depressions. In 2008, when investors purchased faulty mortgage-backed securities (MBS), it was difficult to find buyers when the market collapsed.

By 2004, U.S. homeownership had peaked at just under 70%. Then, in late 2005, home prices started to fall, leading to a 40% decline in the U.S. Home Construction Index in 2006. Many subprime borrowers were no longer able to withstand high interest rates and began to default on their loans. Financial firms and hedge funds that owned in excess of $1 trillion in securities backed by these failing subprime mortgages also began to move into distress.12

The Role of Intrinsic Valuation in the Greater Fool Theory

One of the reasons that it was difficult to find buyers for MBS during the 2008 financial crisis was that these securities were built on debt that was of very poor quality. It is important in any situation to conduct thorough due diligence on an investment, including a valuation model in some circumstances, to determine its fundamental worth.

Due diligence is a broad term that encompasses a range of qualitative and quantitative analyses. Some aspects of due diligence can include calculating a company’s capitalization or total value; identifying revenue, profit, and margin trends; researching competitors and industry trends; as well as putting the investment in a broader market context—crunching certain multiples such as price-to-earnings (PE), price-to-sales (P/S), and price/earnings-to-growth (PEG).

Investors can also take steps to understand management (the effects and methods of their decision-making) and company ownership (via a capitalization table that breaks down who owns the majority of company shares and has the strongest voting power).

Real-World Example: Bitcoin and the Greater Fool Theory

Bitcoin's price is often cited as an example of the greater fool theory. The cryptocurrency doesn't appear to have intrinsic value (although this is an area of debate), consumes massive amounts of energy, and consists simply of lines of code stored in a computer network. Despite these concerns, the price of bitcoin has skyrocketed over the years.

At the end of 2017, it touched a peak of $20,000 before retreating. Attracted to the lure of profiting from its price appreciation, traders and investors rapidly bought and sold the cryptocurrency, with many market observers positing that they were buying simply because they hoped to resell at a higher price to someone else later. The greater fool theory helped the price of bitcoin zoom upwards in a short period of time as demand outstripped supply of the cryptocurrency.3

The years 2020-21 saw Bitcoin rise to new highs, topping $60,000 and hovering above $50,000 for weeks. This time, however, large institutional investors and corporations such as Tesla and PayPal have been involved in the buying—and it is debatable whether or not they can be considered fools. So, perhaps Bitcoin is not an example of the greater fool theory, after all.3

Yahoo Finance. "Dow Jones U.S. Home Construction Index." Accessed May 7, 2021.

Statista. "Homeownership Rate in the United States from 1990 to 2020." Accessed May 7, 2021.

Coindesk. "Bitcoin." Accessed May 7, 2021.

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