What is the Greater Fool Theory, and why does it matter if you’re planning to invest money?
Also known as the Volatility Universal Theory, the Greater Fool Theory is an economic theory that states that when markets are volatile, the average investor is likely to make less money.
The idea behind the Greater Fool Theory is as follows:
- When the market is up, the trader who places the most money into a trade will win.
- When the market is down, the trader who places the least money into their trades will win.
- When the stock price rises significantly, the trader who places the most money into their trade will win.
- When the stock price declines significantly, the trader who places the least money into their trade will win.
- When the stock price rises significantly, the trader who places the most money into their trade will lose.
- When the stock price declines significantly, the trader who places the least money into their trade will lose.
The greater the volatility, the greater the chance the average investor will lose money when investing in a security. This article gives a more in-depth explanation of a theory that has been used to predict the stock market successfully.
How the theory is used to describe the behavior of average investors
The theory helps to describe why average investors never truly win, no matter how many stocks they buy and sell.
An individual investor will inevitably lose money over time because they must sell some stock when the price is higher than the purchase. Someone willing to buy these stocks at this higher price is a “greater fool.”
So even if an investor buys a stock when the price is low and sells it when the price is high, they still lose money. Their winning trades will always match losers, eventually causing them to incur net losses in their portfolio over time. This can be explained by looking at odds. The odds of each trade are 1 to 1, but the actual outcome can be anything because of the random nature of the stock market.
The price of a stock rises or falls at random
This theory is based on the fact that stock prices fluctuate randomly and unpredictably. So even though it is possible to predict how an individual stock will behave, the result will still be different each time an investor bet on a particular outcome.
Because no trader makes their purchases solely based on one trader’s prediction, this randomness prevents average investors from winning consistently over time. An investor who sells when the price is high and buys when the price is low will eventually lose money.
The theory predicts a visitor for everyone
The theory predicts that there will ultimately be a buyer for every stock that every investor buys. This visitor is typically referred to as a “greater fool” because they are willing to buy more of a stock at an even higher price than the original investor paid.
The price of a stock can only rise so far before the greater fools show up because, at some point, it will become too expensive to use as an investment for even greater fools. The stock price will eventually reach its maximum, and the original investor will have to sell.
An investor stops out of a stock when the price is too high
This theory does not say that an investor will not buy a stock when it’s too expensive. In that case, they might lose money because the price is much higher than they planned on buying it.
According to this theory, these greater fools could still show up later and take over the stock at a lower price. But the greater fools will eventually take over the stock at a price that allows for a profit to be accumulated.
The less risk an investor takes, the more money they will make
The theory says that some investors are likely to make more money than others, regardless of their risk. It’s only possible to make money when an investor takes less risk than their competition.
Suppose the risk taken by all investors is identical. In that case, the average investor will always lose money over time because they can never benefit from the volatility in the market by buying low and selling high enough to offset their losses.
Because average investors can never consistently predict the stock market, they will always be at a disadvantage over those who have spent less time in it.
Investors earn money whenever they sell more than they buy
So even if an investor happens to buy a stock when it’s low and sell it when it’s high, they are still at risk of losing money because their net purchases must be less than their net sales. In this case, they will lose money if their stocks decline in value while they own them.
So the theory says that even the best trades are only profitable if the profit made off of each trade exceeds its cost.
The only rational reason to trade stocks
The theory is not a business strategy but rather a theory made up of a trader who has never lost money. It explains why their trades have always had their winners and losers, and why they have never experienced large losses or high gains.
The theory explains why you will sometimes make money in stocks but sometimes lose money. You always lose more than you win, but some days you win more than others. This theory does not explain why you are often an even worse investor when it comes to mutual funds or bonds than stocks because there is virtually no opportunity for people to do well with those investments.
Why individual investors are almost always losers
This is a theory that explains why individual investors are almost always losers when they invest in stocks. It predicts that by the time an investor sells a stock at a profit, another investor will be willing to buy it at a higher price than the one they paid.
Both investors think they will benefit from the market’s volatility this way, but neither of them will realize their profits. The theory says that an investor who buys low and sells high will still lose money over time because they must inevitably sell their high-value purchases at lower prices than they bought them for. This is because another person will be willing to pay more for these stocks.