The Greatest Fool: One Way Bubbles Bloom

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There are many factors that contribute to an economic bubble. One of the most prevalent, obnoxious ways they’re accelerated is thanks to the Greater Fool Theory.

What is a Bubble?

First, we should probably define what we mean by a ‘bubble’. Bubbles occur when the market value of something ends up getting inflated far beyond its real value. The price will keep rising and rising up until people start to realise what’s happening, that the asset is massively overvalued.

At this point, people know what’s coming. They’ll start selling the asset, predicting that the “burst” is on its way. As more people sell, the price starts declining. As the price starts declining, more people start selling.

This feedback loop goes on until the asset’s market value takes a nosedive and bottoms out far below its peak. This is the bursting of the bubble.

Can’t We See Bubbles Coming?

You would think, with the amount of bubbles that have come and gone – some more severe than others – that we would be able to recognise them when they appear. The thing is, sometimes we can. Sometimes, we play along anyway. That’s where the Greater Fool Theory comes in.

Selling to a Sucker

Let’s come up with a hypothetical scenario where big, painted, ceramic eggs are suddenly the hot new asset on the market. The craze is sweeping the news, and everyone is clamouring to own one of these trendy new statement pieces. Their price rises higher and higher as the hype increases.

You, a perfectly rational person, recognise that this is nothing but a fad, that the painted egg market is a bubble in the middle of its rise. You don’t actually think the eggs are worth anything if stripped down to their real value.

But, you know that other people think they do have value.

So, you buy a bunch of painted eggs, wait for the price to rise even more, which you know it will, and then offload them onto some idiot – some fool – who has given in to the egg hype.

But, what if that “fool” has the same mentality as you? What if the person who sold you the eggs in the first place thought you were the idiot?

Finding the Greatest Fool

This is how the Greater Fool Theory works, and why it’s so insidious. People will often buy assets within a bubble, knowing they have no real value, simply because they believe they’ll find someone else, a Greater Fool, to buy them for a higher price. This is all well and good, unless a large proportion of people driving up the price of the asset are those with this mentality.

And, of course, there won’t always be a Greater Fool. At some point, someone will buy the asset and will be unable to find someone foolish enough to buy it off them for a higher price. The bubble bursts, and the Greatest Fool is left with a garage full of big, painted, ceramic eggs they don’t want.

Conclusion

Bubbles are complex beasts that are often difficult to identify and even more difficult to control. Of course, they aren’t helped by people who willingly and knowingly participate in them.

Just because you can find a Greater Fool, doesn’t mean you’re not a pretty Great one yourself.

Take it With You

No time to read now, or want to have it to refer to later? Download the PDF here!

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