There’s a hypothesis in investing called the Greater Fool Theory. According to this theory, it is possible to make money on an investment as long as there is someone willing to pay more than you (i.e. the greater fool). It doesn’t matter if the investment is overvalued or not. As long as there is a greater fool, you can’t lose.
This might sound good, but there is one problem: how do you know who is the greater fool?
Is it you?
Playing the Auction Game
“Going once… going twice… sold!”
If you are the last bidder in this scenario, you’re either elated or you’re devastated. Either you just bought exactly what you were looking for or you just got stuck with the bill.
At an auction, there is a tendency to get competitive. You are bidding against everyone else, and things can get heated at times. When emotions heat up, people make rash and irrational decisions. Often, in an auction, the desire to win takes over, and the “winner” of the auction game ends up paying much more than needed.
Even though you may have “won” that bid, you still lose. By paying more than market value, you are the greater fool.
Jennifer Duke in this article has some advice to avoid overpaying: know your limits and do your research.
The same goes for investing in stocks.
Always know how much an investment is worth to you. Spend plenty of time doing market research, comparing stocks, and reading up on the market and company developments. Only then are you ready to invest.
Don’t Give Too Much for the Whistle
When he was seven years old, Benjamin Franklin skipped into his local toy shop with a pocket full of money. Immediately upon entering, he was drawn to the sound of a boy’s whistle. Ben Franklin was so enamored by its sound he offered all of his money to buy the whistle.
After his purchased, Benjamin ran home to show his family his new toy. He played it so much, his family started to become annoyed with it. When he started bragging to his brothers and cousins about his purchase, they told him that he got ripped off.
Benjamin Franklin ended up paying four times as much for that whistle than it was worth. Instantly, the joy he got from his whistle completely vanished.
By realizing he paid too much, he regretted his purchase and couldn’t enjoy his whistle anymore. The sound of it only reminded him of a terrible mistake he made.
The same goes for stocks. When you pay too much on an investment, you risk becoming the greater fool. By the time you realize your mistake, it’s already too late. Buy at a fair price to avoid regretting your purchase.
Stock Market of Fools
Every once in a while, an investment comes around that seems to go up forever.
In 1999, it was Yahoo and Microsoft. Yahoo peaked on January 3, 2000 and dropped 98% in the next one and a half years. After the dot-com crash, it took Microsoft 16 years to get back to it’s 2000 highs.
In 2017, Bitcoin took the world by storm. It peaked in December 2017, and dropped 84% over the next year.
Now, in 2020, we’re here again. As of October 2020, Tesla is trading at 1,000 times earnings, PayPal is nearing the value of Mastercard, and Snowflake, a company that lost $350 million in fiscal year 2020, has the same market cap as Goldman Sachs.
And these aren’t the only ones. There are plenty more stocks that are trading at all-time highs, and several that have already seen a spike and drop (Nikola, Kodak, etc.).
Weighing Your Stocks
Famous value investor, Benjamin Graham, once said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
In the short run, stocks can achieve wildly outrageous valuations. Speculators and day traders pile into stocks to make a quick buck. The most popular stocks enjoy these short term gains.
Eventually, for one reason or another, the stock in question will be measured. After all, if a stock is a piece of a business, the underlying business has to remain in business. If the actual results don’t match the recent price upswing, eventually the stock price will tumble.
When? No one can predict. You may be fine. There might be a greater fool out there willing to pay even more. Or you might lose half your money in an instant. Whenever it may be, you can be sure that your stocks will be weighed eventually.
There’s a saying in the stock market: it goes up like an escalator and down like an elevator. Gains are slow and boring. That’s how it should be. Done right, investing is a very boring endeavor. Compounding takes time.
It’s when people start looking for a get rich quick scheme that things fall apart. Being a great fool can be profitable if there is a bigger fool than you. If not, you could be sealing your fate. Are you willing to take the risk?
Featured photo source: Andrea Piacquadio on Pexels.com