Greater fool theory

The greater fool theory states that the price of an object is determined not by its intrinsic value, but rather by irrational beliefs and expectations of market participants.^[1] A price can be justified by a rational buyer under the belief that another party is willing to pay an even higher price.^[2][3][4] In other words, one may pay a price that seems "foolishly" high because one may rationally have the expectation that the item can be resold to a "greater fool" later.

Examples

In real estate, the greater fool theory can drive investment under the expectation that prices always rise.^[5][6] A period of rising prices may cause lenders to underestimate the risk of default.^[7]

In the stock market, the greater fool theory applies when many investors make a questionable investment, with the assumption that they will be able to sell it later to "a greater fool". In other words, they buy something not because they believe that it is worth the price, but rather because they believe that they will be able to sell it to someone else at an even higher price.^[8] It is also called survivor investing. It is similar in concept to the Keynesian beauty contest principle of stock investing.

Art is another commodity in which speculation and privileged access drive prices, not intrinsic value. In November 2013, hedge fund manager Steven A. Cohen of SAC Capital was selling artworks at auction which he only recently acquired through private transactions. Works included paintings by Gerhard Richter and Rudolf Stingel and a sculpture by Cy Twombly. They were expected to sell for up to $80 million. In reporting the sale, The New York Times notes that, "Ever the trader, Mr. Cohen is also taking advantage of today’s active art market where new collectors will often pay far more for artworks than they are worth."^[9]

See also

• Arbitrage
• Bagholder
• Economic bubble

References

1. "Greater Fool Theory Definition - What is Greater Fool Theory?". Investorglossary.com. Retrieved 2015-03-06.
2. "What is greater fool theory? definition and meaning". Businessdictionary.com. Retrieved 2015-03-06.
3. Fox, Justin (2001-06-11). "When Bubbles Burst Tulips. Dot-coms. Hey, manias happen. But most don't lead to economic disaster. - June 11, 2001". Money.cnn.com. Retrieved 2015-03-06.
4. "What is GREATER FOOL THEORY? definition of GREATER FOOL THEORY (Black's Law Dictionary)". Thelawdictionary.org. Retrieved 2015-03-06.
5. "`Greater Fool Theory` Can Lead To Expensive Home Investment - Chicago Tribune". Articles.chicagotribune.com. 1986-07-12. Retrieved 2015-03-06.
6. "What is the Greater Fool Theory? (with pictures)". Wisegeek.com. 2015-02-17. Retrieved 2015-03-06.
7. "The Greater Fool Theory: Managing and Modeling Risk - The Finance Professionals' Post". Post.nyssa.org. 2010-07-21. Retrieved 2015-03-06.
8. "Greater Fool Theory Definition". Investopedia. Retrieved 2015-03-06.
9. "Steven A, Cohen to Sell Works at Sothebys and Christies". The New York Times. Retrieved 2015-03-06.