The Greater Fool Theory

The Greater Fool theory works like this; you buy something at a high price, but paying too much is okay because you figure you can find a fool greater than you to buy it later. So, it was okay to pay over $100 a share for Yahoo back in 1999 because there was a lineup of people wanting to buy the stock. You buy high and hope to sell higher. After all, how can you lose? The Dom Com was booming and the internet money train was running at full speed. However, the party eventually has to end because all bubbles will eventually burst. The one who gets burn in this process is the last person in – the Greater Fool – the one who paid $108.17 per share of Yahoo and then watch it drop to $4.41 in 2 years.

Lots of assets have attracted fools – stocks, gold, real estate, etc. Of all the asset classes the most dangerous for fools is most likely real estate because it’s the easiest to finance. Most fools would shake at the thought of buying $500,000 of stocks but think nothing of paying $500,000 for a house. The last real estate bubble happen in the late 1980s and lead to massive losses of wealth in the early 1990’s, as thousands of Greater Fools regretted having bought at the very top of a cycle.

Today we are in another real estate bubble. The demand is being fuelled by two things; low interest rate and a belief that housing prices will keep going up. Making things worst is the fact that people can to buy a home today with no money down. Not only have several of the big banks brought in nothing down mortgages, but the Canada Mortgage and Housing Corporation (CMHC) is endorsing home purchases by fools with no savings. So now you have fools who shouldn’t be buying homes getting into the market.

Ever since the events of Nine Eleven, real estate has been the asset of choice, since for most fools it represents most of their wealth – very few fools have a lot of assets outside of their homes. The last real estate crash happened more than 17 years ago and fools have very short memories. As a result, mortgage debt has exploded right along with house prices. Mortgage debt is at an all time high. Homes in BC went up nearly 20% last year, at a time when inflation was less than 3%. Right now, there is no shortage of Greater Fools.

Fools who neglect history are doom to repeat them. The cost of borrowing has been steadily increasing. And as rates rise, demand will inevitably fall as fewer fools qualify for financing. Finally, when the average house becomes too expensive for the average family to afford, then the last fool will have bought in. The last time this happen, the Greater Fool had to wait 14 years until another Greater Fool came along.

I should note that there is no such thing as a Greatest Fool because there will always be one fool who is greater than you. So if you ever get into a situation where you are the Greater Fool, take heart in the knowledge that another Greater Fool will eventually come along.

You just may have to wait a while.