Greater Fool Theory

Remember in the late 90s when everyone was taking cash out of their homes to buy tech stocks? This buying frenzy was not based on in-depth analysis, but simply because the market seemed to go no where but up. It didn’t make any sense, in fact it was dumb, but it was too easy to just jump in and count on someone dumber coming along to take the the investment off our hands at a higher price. Putting your hard-earned money into questionable investments just because they’re going up at a given moment doesn’t make sense, but that fact hasn’t kept us from making the same mistake time after time.

In 2006 and 2007, we did it again with with real estate. Remember watching homes in your neighborhood seeming to double in value in just a few months? We all had a feeling things just didn’t add up but we continued to play along because we thought there would be someone more foolish. Well, it turns out there is a name for this behavior. The Greater Fool Theory was best exemplified in the now infamous statement made by Citibank’s John Prince in late 2007: “When the music stops…things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” This is the Greater Fool Theory on a scale that might have never been seen before. Now know that at the time Prince made this statement the music has already stopped.

And therein lies the risk of investing based on the Greater Fool Theory: it’s awfully difficult to know when the music will stop.

You Can’t Fight the Fed
There is even an investing strategy that relies on the Greater Fool Theory. Sometimes referred to as momentum investing, you’ll often hear momentum investors say things like, “the trend is your friend,” and “you can’t fight the Fed.” The theory is the same: it might not make sense, but you have to keep dancing while the music is playing. In the case of not fighting the Fed, which we’re hearing a lot about right now, the idea is that as long as the Fed is providing liquidity the market will continue to go up. You might have heard this referred to as the “carry trade.” If you can borrow money at basically zero and invest it into assets that go up, you have to stay on that train. But again as soon as the Fed hints that the music will stop, the party will end quickly.

A few very smart (or lucky) investors may be able to get out before the music stops, but for the vast majority of us it’s far too difficult to know when the music will stop. Again think of Prince, Citibank, and all the other investment banks that are supposed to represent the smartest talent money can buy before the credit crisis. Like Buffet said, “When the tide goes out, we find out who was swimming naked.”

History made it clear that when the music stopped the folks that were supposedly the smartest were left dancing. The question I have now is whether we’re doing it again. Are we continuing to dance because Ben Bernanke and the Fed has pledged to keep the music playing? Are we all ready to pile into the market simply because it is going up? Are we buying gold because it represents a good investment, or because we’re relying on someone more foolish than we are to buy it from us for more?

There’s always a temptation to jump into the market when it’s going up, particularly if you think someone more foolish than you will come along to make your gamble work. You’ll also notice that during times like these that people we considered very smart are suddenly dumb. (Remember how many magazines made fun of Warren Buffett for avoiding tech stocks? It became fashionable to say he was a grumpy, old man who’d lost his touch.)

So you need to ask yourself when you go to invest your hard-earned money whether you’re making a particular decision because you think it’s a good investment. Or are you doing it because you’re relying on a greater fool to come along?

Carl Richards - BehaviorGap.com

This sketch and post originally appeared at the New York Times on October 26, 2010.