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What is the greater fool theory?

Illustration.The documents are on the table

As the name suggests, the greater fool theory means that there is always a bigger fool who will be willing to purchase securities at a higher price, whether or not these securities are overvalued. 

An overvalued stock is defined as an equity traded at a price that cannot be justified by the company’s fundamentals. An extent to which the stock is overvalued can be measured by the stock’s price-earnings (P/E) ratio or price-to-book (P/B) ratio

The trend of purchasing overvalued securities may continue until there are, effectively, no “greater fools” left in the market. However, investors must exercise due diligence to use the greater fool theory of investing as a strategy in order to prevent becoming the greater fool themselves. 

Greater fool theory explained

For those looking for a detailed understanding of what the greater fool theory means,  it’s essential first to grasp the concept of a market bubble

Market bubbles are economic events or cycles during which the prices of assets increase drastically, far surpassing their fundamental value due to an irrational optimism in the markets. 

It is during a market bubble that the greater fool theory definition may be useful for investors, as some will try to purchase the already-overvalued securities to sell them in the hopes of a profit at a later stage of the market bubble, before the eventual bubble burst – or crash – takes place.

 Example of the greater fool theory

An appropriate example of the greater fool theory would be the dotcom bubble in 1999–2000. The dotcom bubble refers to the strong rise in US technology stock prices in the late 1990s, owing to the rash of investments in internet-centric companies during the bull market. 

During the dotcom bubble, the value of the equity markets surged, leading the technology-laden Nasdaq Composite (US Tech 100) stock market index to reach a peak of 5,048 on 10 March 2000. 

The bubble did not last long, as one internet company after another began to witness a plunge in its stock price, leading to a tumble in the internet sector. This went on for the next two and a half years. 

The Nasdaq Composite index came down to 1,139.90 on 4 October 2002, indicating a plunge of 76.81% from its 10 March 2000 peak.

The optimism with which investors went on to buy internet stocks during the period reflected their hope that the firms would one day please shareholders with much larger returns than the amount invested. This optimism may be described as applying the greater fool theory of investing as a strategy, although it led to huge losses once the dotcom bubble burst.

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