Greater Fool Theory: We're All Dumb, Says Science
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The Greater Fool Theory: We’re All Dumb, says Science

January 19, 2016

Have you ever noticed how folks who routinely talk about investing seem so damn sure of themselves? Hey, we’re pretty guilty of it too, so it’s probably about time that we pulled our heads out of the sand and looked at some of the hard truths about investing.

Let’s take a moment and talk about the stock market for those who might not be 100% clear on how it all works. The stock market is a big, ugly marketplace where dopes like you and me buy and sell securities (stocks, bonds, mutual funds) in the hopes of seeing their securities inexplicably increase in value so that we can turn around and sell those securities and make some hard-earned (haha) cash.

When you buy a stock, for example, you’re buying directly from another dope who’s looking to sell his stock. So the question you’re asking is typically, “why would that guy want to sell his stock? Doesn’t he know it’s going to take off and make me filthy rich?” And yes, you’re definitely thinking that, unless you buy stocks with the intention of losing money. Well done.

What you’re probably not considering is that other guy is thinking exactly the same thing – “why would that guy want to buy my stock? Doesn’t he know it’s probably not going to perform well in the future? Sucks to be him.”

This, friends, is the concept of the Greater Fool Theory, and that Greater Fool is almost always you, unfortunately. Let me explain.

Investors can be fickle

The value we place on securities in the market is primarily driven by irrational beliefs and expectations of those participating in it. You might sometimes wonder why a company that makes no money can see steadily increasing stock prices, while an established industry might see its stock values tanking in the same day.

Who the hell knows?

Within a group of 100 investors, there might be one amongst them who actually takes the time to study a company’s financials and make an educated guess as to whether it could see a return and be worth investing in (though in the end, it’s still a guess). From there, the other 99 investors might take notice and join in as well. This, in turn, will often drive up the price of this stock being purchased due to the demand.

The next day, the company might report an E. coli outbreak, at which point, those 99 dummies LOSE THEIR SHIT. The sudden selloff ends up driving that price way down. This might ruffle that 1 smart investor’s feathers, causing him to sell as well.

The other side of the fence

Taking the example above, we might not be considering the fact that those 100 investors are buying from (then selling to) other investors. When that 1 smart investor bought that stock, he bought it from investors who were thinking, “this stock is a loser. I need to get rid of it.”

When the stock started to tank, they sold it to tough-as-nails investors who were thinking, “sure, it’s tanking now, but it will recover, and I’ll be rich when it does.”

Who, in this example, is the Greater Fool?

To answer this question, you might need to examine which side of the fence you would’ve been on in the first place. Do you jump into investments among a herd of other hungry investors? Do you take the time to make educated decisions on whether or not to invest in a stock? Do you buy when the price is low, and sell when it’s high (or the opposite)?

In the end, no matter how you answer those questions, the fact remains that the other side of that transaction thinks you’re the idiot. And when it comes to investing in the market, we all rely on these Great Fools to make money.

And it begs mentioning that this doesn’t just apply to stocks and bonds. Just look at collector’s items like fine art. Who determines whether an art piece is worth $100K or $1? It all comes back to the Greater Fool Theory. Did you just recently buy a super expensive piece of art? Congratulations; you’re the Greater Fool until and even Greater Fool comes along and buys it from you.

Ok, so what?

As an average investor, you simply will never know more than the “experts” on Wall Street about any particular stock. When market-affecting news hits the media, the analysts and traders already know about it, and they’ve already made the moves that you’d probably end up making yourself. That being the case, we’re playing a constant guessing game and playing against some of the smartest people in the country (specifically, they have access to unlimited amounts of knowledge, connections, and statistical data).

What do you have? Google Finance?

Look, I’m not questioning your ability to be a badass stock investor. If you’re doing well, send us an email and let’s talk. But as a general rule of thumb, the average investor could never hope to achieve massive riches by dabbling in the stock based on anything other than pure luck.

In the end, it might be time to stop trying to find the needle in the haystack among stocks, and just buy the whole damn haystack. And if I had one other piece of advice when jumping into the stock market, it’s this:

Don’t be dumb.

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  • http://www.myricketyroad.com MrRicket

    The Google Finance bit made me giggle 😛 I am relying on broad cap ETFs in different major economies all traded in my currency, Euro. That’s fool proof I guess/hope.

    • http://savemoneydammit.com Save Money, Dammit!

      Glad to hear it! That sounds like a solid investment strategy. Seems to be well diversified (we’re doing the same). Almost any broad market portfolio is a winner in my book.

      As always, thanks for stopping by and commenting!

  • http://www.frugality2freedom.com/ Frugal2Freedom

    The stock market is based on people willing to gamble. It is an educated guess at best.
    Consumers are fickle and it is very hard to know what they want and will want in the future. That is why I invested in a good mattress. 🙂