Many people make investments in high-risk assets because they don’t understand the greater fool theory. Countless people have lost their life savings because they don’t understand this theory. Let’s take 5 minutes to understand this theory and its implications on your long-term finances.
It is common for people to buy assets with the conviction that they can sell it for a higher price later. They are convinced that someone else will buy their asset for a greater price in the future. People buy property, stocks, coins, art, and other assets hoping that someone will offer a more favorable price in the future. This is called the greater fool theory. You buy something with the hope that someone else will pay more to buy it from you.
The most you can make from this type of investment is once. You only make money when you sell it and only if someone pays more than you paid for it. This contrasts with a stock that pays monthly dividends or rental property. In such an investment you make money while you own the asset, not just when you sell it.
What if no buys this type of investment from you in the future? What happens then? You lose all or part of your original investment.
Suppose there is a hot new crypto currency in the market. It is called crazycoin. It has a great story behind it and everyone is talking about it. You buy it. Next week you double your money. You brother hears about it and buys it. He doubles his money. Your neighbors also get excited. As more and more people want it, its price skyrockets. This is because everyone is selling it at a higher price. There is a lot of excitement. Everyone is making money and everyone is recommending crazycoin. A bubble is forming. Eventually, a time comes when the number of people wanting to buy are less than the number of people wanting to sell. When this happens, the price starts dropping. As the price falls, people panic sell. Suddenly, people realize that all they have is a number in their smart phone. Everyone wants to sell and no one wants to buy. The bubble bursts. People lose a lot of money. All this happens very rapidly but the financial pain will last for the remainder of their lives.
There have been numerous bubbles before. There are many bubbles in the market today. There will be many bubbles in the future. Most people only realize that are in a bubble after it pops. This raises a question. Is there something we can do to avoid asset bubbles?
Yes, there is a way to avoid bubbles. Think of an orange tree. A seed grows to a tree, bears fruit, and the seeds of the fruit bear more trees. There is a compounding effect. A single seed grows to a grove of trees given enough time. A pinecone becomes a forest.
This is how you should view an investment. An investment produces something of value just as a tree bears fruit. Microsoft produces software we all use. What does crazycoin produce? Nothing. It is a form of payment not recognized by 99.99% of businesses worldwide. The investor will just have to wait for a greater fool to buy it from him. Microsoft offers a portion of its dividends in cash. That is money in your pocket. It reinvests another portion to grow, create new software, and invest in new ventures. This investment grows the value of your stock and will help you earn more profit in the future. This is your orange tree. Note that I am not recommending Microsoft stock as an investment. I am just using this as an example. We have to do a proper valuation before deciding to buy any stock.
What separates an investment from a risky bet? An investment is the purchase of an asset that produces something of value. It is reasonably priced. Everything has a fair price. Would you buy a Toyota Corolla for $300,000? Of course not. Why would you pay ten times its worth. The same is true for investments. They should only be purchased at or below their intrinsic value. An investment does not require a greater fool to buy it from you for you to profit from it. Crazycoin is only profitable when you sell it at a higher price. Microsoft gives dividends while you own it. You earn profit while owning it. A rental apartment offers value to the renter and earns you income while you own it.
Sooner or later, the hype around every investment dies. When that happens, those holding the investments realize that they were greater fools. When looking to invest, seeking safety of your capital. Ask a few questions. Does this investment offer any value? Will it earn me income or profit while I own it? Do I need to find a greater fool to buy this investment from me. What will happen when the excitement dies around this investment. What is the worst case scenario? Will I lose 50%, 75%, 100%, or even more than what I invested?
