The Greater Fool Theory of Investing

This meme-comment by Stephen Diehl alludes to the Greater Fool Theory (GFT) of investing, a theory which helps explain the behavior of those who “invest” in cryptocurrency. The general idea is that some investors are willing to invest in a questionable asset, even if the investment does not make sense to them (i.e. they knowingly make a foolish investment). They do this because they assume that there are even greater fools out there who will be willing to buy the asset at an even greater price.



The GFT can also help explain other kinds of investing – e.g. investing in gold and silver. As for gold and silver, some will try to argue that these metals do have some industrial uses. However, the easy counter argument is that gold and silver are not scarce relative the industrial demand for these metals.

The meme-comment conflates “real money” with stock prices. Real money is actually created by the central bank of a given country. It can be used as both a store of value or a medium of exchange. When a central bank buys government bonds (or corporate bonds), this practices lowers interest rates, all other things being equal. Lowering interest rates inflates the value of the bond market and other asset classes such as housing and the stock market.

Growth stock prices can be influenced by those betting that a sector or a given company will grow. This happened during the dot-com bubble, especially towards the end of the dot-com bubble. In this case, the Greater Fool Theory was used to explain the dramatic rise in stock prices as well as its eventual collapse.

When a market for a given asset class is in a bubble, the underlying value of the assets in that class cannot explain its dramatic increase in value. A large part of the speculation in said asset class can often be explained by the GTF. And, as I mentioned earlier, when entire stock markets go into a bubble, it can be partially explained by the bond buying activity of the country’s central bank.

The stock markets in the US today can partly be explained by the fact that the Federal Reserve has held nominal interest rates near the zero-level bound since 2008. This is especially true of short term interest rates. This policy has inflated the bond market since interest rates and medium-to-long term bond prices move in the opposite direction. Also, when people dump bonds, they need to put their money somewhere, which often means they put their money in stocks. Also, when interest rates are low, company managers find that they can jack-up their firm’s stock price with a stock buy-back program. This is especially nice for managers who have been reimbursed with stock options in their company. In any case, when interest rates are low, companies are in a good position to buy back their own stock with borrowed money. In other words, they keep on adding leverage to their company’s balance sheet.

By looking at ratios such as the stock market’s price-earnings ratio, one can see how far a stock market has risen above the fundamentals that help determine its value. One best known PE measures of market value is Robert Shiller’s famous CAPE ratio (i.e. the cyclically adjusted PE ratio). Another similar ratio, knows as the Warren Buffett ratio, is the Wilshire5000/GDP ratio. This ratio is actually tracked by the Fed.

References


The Case Against Crypto
by Stephen Diehl
https://www.stephendiehl.com/blog/against-crypto.html


Shiller PE Ratio
https://www.multpl.com/shiller-pe


Wilshire 5000 Total Market Full Cap Index/Gross Domestic Product
https://fred.stlouisfed.org/graph/?g=qLC

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