Are you the Greatest "greater fool"?

Are bubbles consistent with rationality? If they are, do they, like Ponzi schemes, require the presence of new players forever?

Economists and financial market participants often hold quite different views about the pricing of assets. Economists usually believe that given the assumption of rational behavior and of rational expectations, the price of an asset must simply reflect market fundamentals.

Market participants on the other hand, often believe that fundamentals are only part of what determines the prices of assets.

Extraneous events may as well influence the price, if believed by other participants to do so; crowd psychology (such as “herd behavior”) becomes an important determinant of prices.

Technically, a bubble is an economic event in which the prices of specific assets rise dramatically and increase beyond their fundamental value. In general, bubbles are viewed as outbursts of irrationality — self-generating and self-sustaining waves of optimism that drive up asset prices and cause investments to be misallocated.

Bubbles resemble Ponzi schemes and, as for Ponzis, what is needed is the entry of new participants.

The Greater Fool Theory is the idea that, during a market bubble, one can make money by buying overvalued assets and selling them for a profit later, because it will always be possible to find someone who is willing to pay a higher price (i.e., a “greater fool”).

An investor who subscribes to the Greater Fool Theory will buy potentially overvalued assets without any regard for their fundamental value.

Exploit the irrationality 

The first, most obvious, strategy that comes to mind should follow Friedman (1953), which states that rational speculators should stabilize asset prices, by buying when prices are low and selling when prices are high relatively to the fundamental value.

This concept of “buy low – sell high” is nowadays a backbone of finance, but it’s almost impossible to buy at the minimum and sell at maximum.

Given this impossibility, another motto came up in the financial world: “follow the trend”; buy when prices are going up and sell (short) when prices are going down.

An excessive number of trend-following traders could easily lead to overprice and even to bubbles.

In addition, it seems that bubbles are more likely to appear in markets where fundamentals are difficult to assess.

But how to we exploit these moments of irrationality?

George Soros’ description of his own investment strategy offers a good example.

Soros has apparently been successful over the past years by betting not on fundamentals but, he claims, on future crowd behavior. In his view, the 1960’s saw a number of poorly informed investors become excited about rises in the reported annual earnings of conglomerates.

The optimal investment strategy in this case, says Soros, was not to sell short in anticipation of the eventual collapse of conglomerate shares (for that would not happen until 1970) but instead to buy in anticipation shares of further buying by uninformed investors.

The initial price rise in conglomerate stocks, caused in part by speculators like Soros, stimulated the appetites of uninformed and trend-following investors since it created a trend of increasing prices and allowed conglomerates to report earnings increases through acquisitions.

As uninformed investors bought more, prices rose further.

Eventually price increases stopped, and stock prices collapsed. Although in the end disinvestment and perhaps short sales by smart money brought the prices of conglomerate stocks down to fundamentals, the initial buying by smart money, by raising the expectation of uninformed investors about future returns, may have amplified the total move of prices away from fundamentals.

Soros was able to disinvest right before the burst of the bubble, but many of the uninformed investors that were following the greater fool theory, in the end resulted to be the “Greatest Greater Fool”.

And you, are you sure not to be the Greatest Fool?

 

 

 

References

Blanchard, O.J. and Watson, M. (1982) Bubbles, Rational Expectations and Financial Markets. In: Wachtel, P., Ed., Crises in the Economic and Financial Structure, Lexington Books, 295-315.

De Long, J.B; Shleifer, A; Summers, L.H; Waldmann, R.J. (1990) Positive Feedback Investment Strategies and Destabilizing Rational Speculation. The Journal of Finance

V. Bogan (2015) The Greater Fool Theory: What Is It?

Friedman, M. (1953) Essays in Positive Economics