Greater Fool Theory

Tulip mania

In finance and economics, the greater fool theory states that the price of an object is determined not by its intrinsic value, but rather by the local and relative demand of a specific consumer.

In an inflated market, a consumer, despite having broader market knowledge might pay an inflated price because of their needs and the local related-market value. Another consumer, relative to their needs and assessment of market value, may deem the price excessive. Thus, to one consumer, the commodity has a greater value than to another, making the former look like a fool to the latter.

In times of hyper-inflation and in remote regions, the price of necessities is so exorbitant that, relative to normal markets, they can seem arbitrary. Yet the local cost of doing business relative to the price in these regions as well as the necessity to feed and shelter one’s self in a hyper-inflationary crisis justifies through profit or actual benefit the ‘foolish’ price.

In real estate, the greater fool theory can drive investment through the expectation that prices always rise. A period of rising prices may cause lenders to underestimate the risk of default.

A Ponzi scheme is a form of investor fraud where earlier investors are paid from the money gained by more recent investors. In order to stay afloat Ponzi schemes rely on a continuous supply of greater fools who are willing to buy into the scheme. Although a share in such a scheme has no value whatsoever, so long as more greater fools buy into it, it can remain profitable for the investors involved.

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. It is also called ‘survivor investing.’ It is similar in concept to the ‘Keynesian beauty contest’ principle of stock investing (don’t figure out what company to invest in; figure out what everyone else is going to invest in).

Art is another commodity in which speculation and privileged access drive prices, not intrinsic value. In 2013, hedge fund manager Steven A. Cohen of SAC Capital was selling at auction artworks that he had 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’ noted: ‘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.’

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