The Greater Fool Theory is an investment belief that says there will be an investor always to buy an asset however overpriced it is. Thus even if the original investor had paid a higher price than was necessary, he would make a profit as “a greater” fool would buy it from him at an even higher price. In most of the asset markets like real estate, equity and gold, the greater fool theory is applicable. Many people buy an asset thinking or rather hoping its value will go higher and they can sell it. This cycle continues leading to inflationary prices – BUBBLES.
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Read – Should I buy or rent a house? (2012)
Will the greater fool theory benefit you?
It depends on the type of the market. If there is a bubble in the market (real estate or stock), you can be benefited. You buy a stock or invest in a property. In a bubble, there can be irrational buying which can lead to rise in the prices and some buyers will be ready to pay a higher price than is the true value of the asset. On the other hand, if it the bubble bursts or investors as a collective realize that the market is overvalued, there will be no buyers. If you were looking for a buyer to pay a higher price, you will not find one. Some investors sell in such a market leading to further devaluation. Your property/stock can lose value quickly in this market. (It’s better to avoid bubbles than playing smart – it’s like “passing the parcel”, you never know what will happen when music stop)
Must Read – Herd Mentality
The theory can be applicable in different areas
For example, 15-20 years back, working in software companies was considered a lucrative career with a good salary, stock options and overseas assignments. Everyone wanted to become a software engineer and tried every trick in the book to get into Inofsys or TCS. But today, the profession is not so lucrative from a money perspective as there is too much supply compared to demand, companies are trying to right size the staff. Stock options have dwindled and overseas assignments are lesser now or not so attractive. Moreover in the long run, if all engineers work in the software industry, there will be shortage of skilled resources in other industries. They will also suffer consequences of the ‘Greater Fool’ theory.
US Housing Market Bubble
2000-05, there was a housing market bubble in the United States, where the real estate prices went up or were artificially made to rise. People bought houses at these high rates thinking there will always be someone to buy it at an even higher rate as the housing market was going through a boom. But then interest rates began to rise and demand for houses reduced. This led to default in payments triggering a real estate collapse. People ended up having real estate that was worth little at that time and owing big loans that were taken to finance the purchase.
Read – 4 Lessons from the real estate bubble in the US (2012)
Indian Real Estate
In India, we view buying property as a source of wealth and income generation. We buy property thinking it will secure our future generations. Till recently the real estate prices were on the rise to the point of being almost unaffordable to people. But in the last 2-3 years, there has been stagnation in real estate prices. Demand has been decreasing. This is because the prices are so high that people are unable to buy at these levels.(or investors feel they will not be able to find Greater Fool) There have been many regulations in place to curb black money getting invested in real estate and the real estate market was dependent on investors to put money in it. Now investors are slowing down or playing the waiting game. There are new norms for lending to real estate sector which also has brought a slowdown in funds getting pumped in real estate.
Read – Indian real estate bubble, will it ever burst (2012)
Data is irrelevant here but still…
Property prices remained relatively same between December 2014 and March 2015. Prices in the Mumbai Metropolitan Region fell by 2.18 percent. Prices in Chennai, Hyderabad and National Capital Region remained flat (Source: Real estate research and rating firm Liases Foras). This is quite different from earlier when real estate prices were only rising. Moreover, the FICCI-Knight Frank Real Estate Sentiment Index for the period January to March 2015 states that only 15% of respondents in its research expected residential sales to increase.
The chart below shows the year on year percentage change in price of housing in India. As you can see, there is a downward trend in the last 2 years.
| NEW PROPERTY LAUNCHES | |||
| Area | Q1 (2013) | Q1 (2014) | Q1 (2015) |
| Mumbai | 31 | 22 | 9 |
| NCR (National Capital Region) | 27 | 20 | 4 |
| Kolkata | 6 | 5 | 3 |
Source: Livemint
This chart shows the number of new launches in the real estate sector in the first quarter of last 3 years and it can be seen that it has reduced significantly across the country.
Read – Can I afford a House? (2012)
I got a question
I got this comment on “The Art of Thinking Clearly” – it will be great if you can answer..
I am able to readily connect to this article and sub-section “Endowment Effect”.
I have two plots (vacant site) in Bangalore. In one of them, I am constructing the house, by taking home loan from bank. Thinking, should I sell second plot and clear the housing loan or keep it with me to let it grow? If I sell second plot now, may not get much profit. It could barely make break-even of the investment (invested 3 yrs ago). What are your views on this?
Read – Hindsight Bias
What should you do?
If one had bought property a couple of years back hoping to sell it off, he/she will not find a ‘greater’ fool soon as the property market is in the decline phase. (I am the worst timer & predictor of any market) People will not be ready to pay a high price. Experts also believe that it will take a few years now for real estate to regain its original sheen. (not sure but same experts were gung ho few years back) It is concluded by other experts that real estate investment is not as attractive for now and there is a disruption in the market.
My observation (not advice)
The greater fool theory might not be applicable for now here as ‘greater fools’ might not emerge soon and your investment will not appreciate the way it was appreciating in 2004 to 2012 or you will not get returns on investment as expected.
Feel Free to Share your views in the comment section.
Dear Hemant, a good article by you as always. The problem for “ordinary” people like us is that even when we try to buy in such a market, the prices we get are still high. We are told by dealers that the decrease in prices is only on paper, and there is no such thing on the ground. Same is we try to sell or rent our property – we are told market is down and we cannot get a good price. So the common man is always at a loss, whatever be the market conditions and whatever the pundits may say. Nevertheless, thanks for enlightening us with the Greater Fool theory!
Dear Mr Dhruv,
I agree to some extent to what you have mentioned – this is one of the biggest issues with most illiquid asset class “real estate”. Hopefully, with time technology will help us to reduce liquidity issue.
Interesting article.
Thanks Rajiv : )
Thank u Hemant for informative article as always.
But I have seen that media (thru experts sitting on their channel) also misguides a retail investor who can not find for himself true value of a stock.
Dear Sanjay,
Check this…
https://www.retirewise.in/2016/02/keep-away-from-too-much-news.html
Interesting article explaining ‘Greater Fool Theory’
Thanks a lot for sharing the greater fool theory. Well written article I must say, your explanation is easy to understand.
Greater fool theory is always in operation. Peasenhall put up an article on alcoholic annonymous. Similarly effective and infective.Probably more effective,especially the way it operates.
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