Economics 101: The Greater Fool Theory

Housing prices are going to continue increasing for years to come. The real estate market has been on an incredible pricing run for the past decade and some are expecting it to continue for at least a decade more. The appreciation we have seen in home prices, seemingly unstopped and unslowed, causes others to believe we are in a bubble. I recently came across an economics theory that might explain what has been happening with home values – it’s known as The Greater Fool Theory.

The greater fool theory assumes that we, as investors, know we can turn a profit on an asset because we can find a greater fool than ourselves to buy the asset from us at an even higher price. In other words, they buy something not because they believe it is worth the price, but rather because they believe they will be able to sell it to someone else at an even higher price. The greater fool theory states investors can achieve positive returns by buying an asset without concern for valuation fundamentals or any other important factors or analysis. Some folks might even think assets they are purchasing are overvalued but are not concerned as they fully expect to find another investor (the “greater fool”) who will be willing to pay more.

The Greater Fool Theory: Modern Day Scenarios

The greater fool theory can be seen in several different asset classes. Crypto currencies may be a perfect match for this theory. I think we can all point to someone we know who has bought a crypto currency without fully understanding or caring about its use cases, underlying technology, or adoption, simply anticipating the value will go up and they can then sell for a profit.  Beanie Babies are also a good example. What was the real value play in buying small stuffed animals? Simply that someone could resell to someone else for a profit. I always think about high-rise condos in Florida in the run up to the 2008 crash.  Folks were buying condo units before the building was built with the full intention of selling as soon as the building was completed. They never intended to live in it, nor to even rent it.  There was no value add, the buy was doing nothing to justify a higher sales price, simply hoping to find a great fool upon completion.

Real Estate: Who Is The Greater Fool

We as real estate investors can also fall prey to the greater fool theory. Are we all greater fools and are we pushing the real estate market higher and higher?  Although wholesalers often get a bad rap, those that do it well, and do it right, are finding and creating good deals by solving sellers’ problems and delivering deals to investors with enough room for them to add value.  Fix and flippers are very clearly adding value to homes through the repairs and improvements they are making to the property.  The same goes for folks building new construction.

What about the retail market?  Are retail buyers and homeowners building up the market by looking for and hoping to find a greater fool?  People are continuing to buy and sell at ever increasing prices so it might seem as such as folks get caught up in the momentum of the market, but I would argue that we are still somewhat buying and selling based on sound principles.  Retail and individual investors/buyers are thought to be less knowledgeable, less disciplined, and less skillful than institutional investors, so they are often presented with more risky investment opportunities.  But when it comes to buying real estate, there is a team of professionals behind them that are still doing their diligence.  Real estate agents have a fiduciary responsibility to make sure that their buyers are getting the best price.  Lenders are still verifying that the buyers are qualified and can afford the home and price they are wanting to pay.  Good credit is still a requirement.  Buyers are putting, generally, substantial down payments on properties.  Appraisers are verifying that the property buyers are under contract on is comparable to the market.  Generally speaking, NINJA loans (No Income, No Job or Assets) are not available, unlike leading up to the last downturn.  Interest rates are such that buyers can afford the higher prices by helping keep their monthly payments relatively low.  Supply and demand are still very important and in play.  More folks are wanting to become homeowners, home builders have been under supplying the market for years, material costs have been skyrocketing recently, all fueling higher prices.

How To Avoid Becoming The Greater Fool

The greater fool theory also assumes folks are making a short-term investment, trying to profit quickly on the momentum of the market.  Most real estate buyers are not looking to turn their property quickly and most will be utilizing the property as their home and not just an investment.

How do we avoid being the greater fool?

The best way to avoid being the greater fool is to take your time and evaluate the assets you want to purchase and the value that they hold.  Many investors fall for the Greater Fool Theory because of the promise of making a big profit in a short period of time.  They don’t carefully analyze the market nor the deal in front of them.  Formulate an investment plan, stick to the plan, avoid the temptation of getting rich quick and deals that seem too good to be true.  And don’t forget to reach out to Pine Financial Group to help anytime!

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