“Greater fool theory states that investors can achieve positive returns by buying an asset without concern for valuation fundamentals and other important factors because someone else will buy it at a higher price.”
Simply stated, investors expect to make a profit on the stocks they purchase because another investor (the “greater fool”) will be willing to pay even more for the stock, regardless if the stock’s price is overvalued based on fundamentals analysis or long-term performance outlooks.
According to The Motley Fool, this philosophy relies on the expectation that someone else will get caught up in market momentum (frenzy) or have their own reasons for why the asset is worth more than the price you paid.
In the short term, popular sentiment plays the biggest role in shaping stock market pricing action, but fundamental factors including revenue, earnings, cash flow, and debt determine how a company’s stock performs over longer periods.
In short, it is possible to achieve strong returns by using the greater fool theory, but it’s risky and far from the best path to achieving strong long-term performance.
Specifically with regard to the stock market, the Greater Fool Theory becomes relevant when the price of a stock goes up so much that it is being driven by the expectation that buyers for the stock can always be found, not by the intrinsic value (cash flows) of the company.
The Greater Fool Theory is a very risky, speculative strategy that is not recommended especially for long-term investors.
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