Tuesday, February 16, 2010

Why investors fall prey to the Greater Fool Theory

To explain the reasons, we must first understand the concept behind the Greater Fool Theory.

During periods of fast economic growth, there is usually a feeling of optimism and excitement all around. New jobs get created, more people have disposable cash, factories produce more and as they find more buyers, they raise prices.

As this process accelerates over a few years, asset bubbles get created - particularly in real estate and the stock market. Every one gets involved in a buying frenzy, and as values escalate, more buyers join the fray with the hope of making a quick profit.

Sooner than later, what was under-valued becomes fair-valued and fair-valuations become over-valued. As long as there are buyers, valuations don't really matter. There is always a bigger or 'greater fool' on whom one can unload a flat in a not-so-great locality (or a stock with questionable management and poor financials) at a higher price.

Many investors have made a ton of money by 'flipping' stocks - selling one at a profit to buy another at a higher price regardless of its fundamentals with the expectation that there will always be some one willing to pay an even higher price.

Such 'momentum' investing seems to work when the bulls are rampaging. It is precisely at such times that new investors start flocking to the stock market - having heard stories about how their friends or neighbours or colleagues are becoming rich overnight.

When a correction takes place, momentum investors find out that they have been the greater fool, as they get stuck with good as well as not-so-good stocks at sky-high prices. Their aim becomes to somehow recover their 'buy price' to break even.

There are only two ways to avoid falling prey to the Greater Fool Theory. The first is to avoid the share market (which many investors do after losing their shirt). The second is to spend the time to learn and understand the concepts of value investing and contrarian investing.

If you buy stocks without any regard to its fundamentals or technicals because you think it is a waste of time, there is a genuine risk that at some stage you will become the 'greater fool'. Over time, the market recognises the better companies because of their good management and sound balance sheets.

Value investing and contrarian investing concepts have been explained in my FREE eBook: 'How to become a better investor'. (Get your copy today, if you haven't done so already.)


joel said...

A very Honest article Sir.

Marshal Nagpal said...

indeed very correct, i have send an email for ebook...please do reply to email.