Who is the Greater Fool?

Here is a little piece I wrote on an official investment theory: The Greater Fool Theory.

The link is the official definition for those interested in it.

I would like to prepare you for the next great stockmarket frenzy.  I do not know when it will come but I know it will come.  I do not know which sector it will be in, but I do know it will be isolated to a particular sector.  In addition, I do know that it will drive prices artificially high and there will be people waiting to buy those assets with the hope of bagging a quick and handsome profit, but will be unlikely to do so.

However, before we go into specifics, let me start with a question!  Have you ever bought anything for more than it is really worth? A share, real estate or something on ebay?

The Greater Fool Theory is based on the belief that even if you pay more than an item is actually worth, you can always sell it to someone else for even more.  The problem with this theory is that you may become the greatest fool and get stuck with the item at the highest price.

There are a lot of doomsayers around the subject of investing.  They explain how they lost money when buying particular investments in the past.  The issue is highly unlikely to be the performance of the asset itself, but more likely to be that the person bought the asset for too much or timed their purchase badly.  They should be blaming themselves for paying too much.  In fact, the person who sold it to them probably thinks it was a great investment.

I have been one of these fools in the past (The Tech boom of 2000), but thankfully I learnt my lesson quickly and started investing again.

The history of foolishness

Investment foolishness is not new.  There are plenty of examples of this in the last past.

The Dutch “Tulip Mania” of the 1630s, was one of the first examples of the rise and collapse of a speculative bubble market.  Other historical examples are the The Mississippi Scheme of 1684,The South Sea Bubble of 1720, the stock market crash of 1929 or the silver crash of 1980.  More recent examples are the dot-com bubble of 2000 and the subprime mortgage crisis of 2008.

In all of these examples, the prices of these assets rose to unsustainable levels, based only on the belief they would keep going up.  But, there was no fundamental value to support those prices, only pure speculation.

History seems to repeat itself, because speculators are still on the lookout for the next hot thing.  And they have already forgotten the hard lessons from the last crash.

So how can you protect yourself?

The simplest way to avoid speculation is to invest wisely and not try to follow trends. What is HOT this year, next year, more than likely will NOT be so.  There is evidence to support this fact.  When assets become the best performing in any one year, the following year they become one of the worst.  This is not always true, but the statistics are stacked in its favour.

Buying assets which have good long term value with opportunity for further appreciation is the best strategy, whether it be shares, bonds, real estate, commodities, hedge funds or other alternative assets.  And when markets intermittently go crazy and asset prices fall, see this as an opportunity to purchase more of those value assets at rock bottom prices.

There will be another crash, when, how, what, and for how long I don’t know.  But trust your decision, that you purchased  good value assets that are currently under-priced and the market will correct this in time.  Don’t get caught in a bubble when it is about to pop.

The big bubble concerns right now are Gold, Commodities and Technology stocks.