Who is the Greater Fool?
“If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy.” - Warren Buffett
"In every trade there is an idiot and if you don't know who it is, it is you" - Meir Statman
On Fool's day, let us talk about the Greater Fool Theory.
Interesting thing about investing in stocks is that there are always (at least ) two points of view for every trade. For every person who is buying a stock thinking the price will go up, there is a person on the other side selling the stock. Now, assuming no insider trading and assuming both the parties have exposure to the same information, it is not clear who has the relative advantage? What this augurs for the intelligent investor is that he should buy/sell only if he is clear in his mind and sure of the reasons for doing so.
There is a concept called the Greater Fool Theory - this means people purchase a stock with the assumption that they will later be able to sell it to a greater fool. In simple terms, this means a person purchases a stock not because they are convinced of it as an investment but because of the belief (or the hope) that it will possible to sell it later to someone at a higher price. Maybe in reality, people don't consciously think of themselves as fools or do they have explicit hope that they will find a greater fool, but their implicit hope is that they will be able to sell at a higher price.
Effectively, the optimism and market momentum is built up for a single stock, an industry or the market as a whole and that market participants realize this only after the price has reached an outrageously high (or low) level. And then, pop goes the bubble!
Related topics:
1. "Keynesian Beauty Contest" as expounded by John Maynard Keynes (in Chapter 12 of his book General Theory of Employment Interest and Money (1936).
2. Efficient Market Theory
PS: Meir Statman is the Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University. You can read his blog at http://whatinvestorswant.wordpress.com/
"In every trade there is an idiot and if you don't know who it is, it is you" - Meir Statman
On Fool's day, let us talk about the Greater Fool Theory.
Interesting thing about investing in stocks is that there are always (at least ) two points of view for every trade. For every person who is buying a stock thinking the price will go up, there is a person on the other side selling the stock. Now, assuming no insider trading and assuming both the parties have exposure to the same information, it is not clear who has the relative advantage? What this augurs for the intelligent investor is that he should buy/sell only if he is clear in his mind and sure of the reasons for doing so.
There is a concept called the Greater Fool Theory - this means people purchase a stock with the assumption that they will later be able to sell it to a greater fool. In simple terms, this means a person purchases a stock not because they are convinced of it as an investment but because of the belief (or the hope) that it will possible to sell it later to someone at a higher price. Maybe in reality, people don't consciously think of themselves as fools or do they have explicit hope that they will find a greater fool, but their implicit hope is that they will be able to sell at a higher price.
Effectively, the optimism and market momentum is built up for a single stock, an industry or the market as a whole and that market participants realize this only after the price has reached an outrageously high (or low) level. And then, pop goes the bubble!
Related topics:
1. "Keynesian Beauty Contest" as expounded by John Maynard Keynes (in Chapter 12 of his book General Theory of Employment Interest and Money (1936).
2. Efficient Market Theory
PS: Meir Statman is the Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University. You can read his blog at http://whatinvestorswant.wordpress.com/
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