The Greater Fool Theory: Foolproof Strategy, or Bubble Waiting To Pop?

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Around the world, global markets have been awash with liquidity as central banks and governments promote quantitative easing. In some cases, central banks are directly participating in purchasing market securities. This flood of money has generally led to higher asset prices across markets, with markets appearing overpriced. Higher asset prices can also be attributable to the greater fool theory, as investors keep selling overpriced assets to other investors (the greater fools). In this article, we’ll examine the greater fool theory and evaluate whether it’s a sound investing strategy.

What Is the Greater Fool Theory?

The greater fool theory states that investors in a bullish market can earn positive returns by betting on an asset without regard to its fundamentals, because someone else (a “greater fool”) will buy it from them at a higher price. 

Investors acting in accordance with this theory ignore intrinsic valuations and fundamentals of assets — even if those assets are overpriced — because they expect to profit when another investor (the greater fool) is willing to pay even more. 

What drives a friendly fool to snap up these overpriced assets, sometimes to their disadvantage? Take meme coins, for example. A crypto wallet that bought $8,000 worth of Shiba Inu tokens last year is currently valued at $5.4 billion. The meme cryptocurrency hit a new all-time high on the 28th of October 2021 — a price appreciation of over 2,000,000% since the wallet bought the first Shiba Inu. For a token that originally started as somewhat of a joke, Shiba Inu may seem incredibly overpriced. It’s hard to argue that the pricing is in line with any intrinsic value. 

These meme coins thrive on internet-fueled hype, and on the fear of missing out (FOMO). They typically have a sturdy army of devoted followers who popularize the tokens and create a cult-like following online. Once an asset price starts to pump, and more people recount how much profit they’ve made, those who haven’t yet bought jump on the bandwagon, no matter how irrational it may be to do so.

Multi-level-marketing schemes (MLMs) are real-world examples of the greater fool theory in practice. Existing members of MLMs are rewarded by selling products to new members they find, who in turn have to find more fresh buyers. 

What Is a Speculative Bubble?

A speculative bubble is a sharp increase in asset prices far above what its underlying fundamentals can account for. This situation usually happens because of an exceedingly optimistic outlook about an asset’s price for the future. The speculation and resulting activity which follow push trading volumes higher. As the exaggerated expectations draw in more investors, demand exceeds supply, pushing the price increasingly beyond the asset’s intrinsic value.

Eventually, the bubble bursts, and the asset comes crashing down as investors panic and sell their positions. The greater fool theory is the underlying principle behind speculative bubbles — and it’s also what keeps them going.

Pros and Cons of Using the Greater Fool Theory

Applying the greater fool theory to crypto markets can potentially give you strong returns. You can only be assured of success if you’ve mastered timing the market. Since a price correction is inevitable, and the bubble will eventually burst, the key to using this strategy is exiting a trade early so you won’t be caught holding the bag — as the last fool.

While it is possible to make good returns using the principle of the greater fool, it’s risky — and there are other ways to achieve excellent long-term performance. 

The first problem is that greater fools are often after assets which are trending. They aren’t interested in stable performers with solid fundamentals, but rather in what’s hot right now. As a result, they tend to be impatient with any asset that slows or cools off, even if it’s for a moment. These trend-chasing investors will jump ship at the first sign of trouble, moving on to the next token that makes the headlines. The issue here is that you could be the one left holding the bag when they go.

The crypto market is volatile by nature. A rise in asset prices is usually followed by a fall. So, the second problem of using the greater fool theory is timing — you have no way of knowing when a price correction will start. If you’ve played the wrong hand, you could end up as the greatest fool.

Lastly, using the greater fool theory is time-consuming. To successfully use this strategy, you must be very attentive since prices change rapidly. It’s best to constantly scan the markets, several times a day. This requires a significant investment of time, energy and discipline. Having the speculative and market trend expertise of a full-time day trader could help. 

At the end of the day, using this strategy is like playing hot potato with a grenade. Even though it’s possible to make money, you’re also taking on a fair bit of risk. 

The Greater Fool Theory in Action: Meme Coins

The greater fool theory approach to investing is dependent on someone purchasing your assets for more than you paid, without any fundamental reason for doing so. 

Nothing illustrates this phenomenon better than the spike of meme coins Dogecoin and Shiba Inu. 

As of October 30, 2021, Dogecoin had returned 17.79% and 45% in the previous 7 and 30 days, respectively. Even more impressive, Shiba Inu had returned more than 900% over the previous 30 days, becoming one of the top ten traded cryptocurrencies. Its market cap reached $39 billion. The value of Shiba Inu also briefly surpassed that of the 8-year-old Dogecoin, which is largely considered its “father.”

Both coins have little underlying value — and yet, they’re making waves and creating crypto millionaires. Although they started as fun projects, they quickly evolved to become a way to make fast returns on investments. 

Meme coins make use of the so-called network effect, and have strong online communities of fans who are active on social media. Social media influencers champion this type of speculation on TikTok, Twitter, and Reddit, etc. People buy because they hope that other people will buy at a higher price from them.

For example, a key factor which helped launch Shiba Inu to the moon was a tweet by Tesla founder Elon Musk, in which he shared an image of the Shiba Inu coin on October 18 of this year. Before the tweet, the coin was trading at $0.000026, and afterward, the price jumped to an all-time high of $0.00008456

However, meme coins cannot survive indefinitely based on celebrity endorsement and internet hype alone. Since they have little intrinsic value and no real-life applications, a bubble burst is highly possible. You could experience massive returns — or significant losses, depending on when you jump in or out.

How to Protect Yourself Against Speculative Bubble Bursts

If your strategy is based on the greater fool theory, then you’re fine with buying overpriced assets and selling them for a profit just because “someone will always pay more” (or so you think). Just be aware that you could lose a great deal of money.

A speculative bubble is a fragile one, and buying an overvalued asset without regard to its fundamental value could leave you exposed when the bubble eventually collapses. The sell-off triggers a sharp dip in the asset’s price, and you’ll lose a lot of money if you’re left with no one to sell to.

However, there are several ways to cut your losses if you’re caught up in a crypto bubble.

  • Use stop-losses. Stop-loss trading orders are an effective tool designed to minimize loss due to price volatility. In placing a stop-loss order, investors automatically liquidate an asset once its price reaches a set threshold. Properly used, stop-loss orders can prevent an investor from being wiped out in the face of a bubble burst. 
  • Rebalance your portfolio. Rebalancing is a way of restoring your portfolio back to the desired asset mix. Rebalancing primarily ensures that your portfolio isn’t solely dependent on a particular investment or asset class’s success or failure. 
  • Use position sizing. Position sizing means choosing the appropriate size of an investment — especially in relation to the risk. For example, you can use a risk management strategy in which you don’t plan to risk more than 2% of your capital on any particular trade. Losing just 2% of your investable capital in a meme coin bubble burst would reduce the otherwise significant impact on your overall holdings.
  • Diversification. Not putting all of your eggs in one basket is a fundamental rule that can be hard to follow, especially if you’re tempted to ride the gains of a particular coin. If you’re determined to ride the fortunes of only one asset, then you’re taking on a significant amount of risk.

The Bottom Line

The greater fool theory’s strategy is a risky one, and is not generally recommended. Successfully implementing a greater fool strategy takes time, effort — and quite a bit of luck. You may also have to pay an excessive amount of attention to the markets, since prices can — and do — change instantly.

Although playing the crypto market based on the greater fool theory could potentially be profitable, there’s also a good chance you could end up being the greater fool. If no other fool shows up, you’ll be left holding the bag.

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