The greater fool theory is a financial philosophy that says that if a stock or other asset prices go up, the market recognizes that the risk it is taking by investing in that stock or other asset is worth it. It is a popular hypothesis that the market is always right. However, it is a very dangerous one to follow. If you believe in this theory, you have to take everything the market does with a grain of salt. Rather than focusing on intrinsic value or the amount a company is worth, this theory considers the market’s sentiment. If the market is right, stocks with high valuations are overpriced, and stocks with low valuations are undervalued. Therefore, this theory suggests that those who buy stocks at the top buy into a bubble, and those at the bottom buy into valuations. This article discusses different ways the greater fool theory can be used.
Stop chasing greater fools.
It is easy to get caught up in the moment, especially in a bull market. You see a stock going up, and you wonder why you aren’t already invested in it. Just because another investor buys into a company doesn’t mean you should as well. It doesn’t mean that the investor has any more information than you do, nor does it mean that that investor has done any more research on the company than you have. Use this theory as a guide rather than buying into the stock yourself. If there is no intrinsic value to the stock, don’t buy it regardless of what anyone else thinks about it.
Take advantage of greater fools when they don’t exist anymore.
Many investors have been caught off guard when a bull market turns into a bear market. They have no idea how to handle the situation, and they lose money as a result. Many new investors would be wise to set aside some money specifically to take advantage of greater fools when they are needed. These people don’t care about what is happening in the stock market but care about their retirement savings or getting interested in their savings accounts. Sell these people stocks that are going up at a time when it is obvious that things will not stay this way forever. You must determine which stocks fit into these categories, but there will always be some available if you look hard enough.
Buy low, sell high.
There is no denying that the greater fool theory is good to follow. It is almost impossible for anyone to time the market, so it is important to take the market’s advice at face value and not second guess yourself. Usually, this means buying stocks when they are weak and selling them when they are strong or have reached their low. However, if you are looking for greater fools to buy stocks for you, this theory can help you do that.
Don’t try to outguess the market on your own either; use technical analysis instead.
Many investors try to utilize this theory, but this is a huge mistake. It is very easy to get wrapped up at the moment and make bad decisions because you are trying to be a greater fool yourself and are ignoring reality. Instead of wasting your time trying to figure out the reason why other people are buying in, use technical analysis so you can see trends, support levels, and resistance levels, which will tell you when it is time to sell your investment. A good trading platform will allow you to track charts with support/resistance levels already applied for making investment decisions.
Take advantage of other people who have no idea what they’re doing.
When the market is tanking, you will find that many people have no idea why or how to react to it. Some people are long on stocks and don’t want to sell. They are waiting for a bounce-back, buying on margin, and not understanding what is happening. While they are holding onto everything falling in value, you can be there buying into their panic as a greater fool.
Use the theory to reverse-engineer stocks.
An interesting fact about stocks is that they can be bought and sold based simply on their name alone. The market has a tendency to assign value to names without anything else attached. This means you can buy or sell a stock based solely on the reputation of that company or its product. You don’t need much information to do this, so it is important to set your limits when buying or selling those stocks. For example, if a company is known for using all-natural ingredients in their products, their stock will likely rise when people start getting more health-conscious and want that product instead of others.
Take advantage of the general optimism of the market.
One of the reasons this theory can be dangerous is that it tends to go along with the market’s general optimism. Since people are happy and optimistic, they tend to buy things on what they perceive as a rise in value. However, you can use this theory as a guide to help you invest when everyone else is buying without any reason to invest or have faith in the stock or asset being sold, and not when there are reasons for buying into an asset.
The greater fool theory is a simple concept to understand and learn but can be more difficult to master. It takes a level of understanding of the market and patience that many investors simply don’t have. Those who are good at spotting opportunities based on this theory can make an incredible amount of money by waiting for the right time to jump on board stocks that are going up in popularity.