Theory of the Greater Fool
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Theory of the Greater Fool

Doug Norton

I promised a potential explanation for why there is so much froth in asset markets. It is not my explanation but one from a famous article from Smith, Suchanek, and Williams. The authors note that with several repetitions individuals learn to behave with rational expectations but it is a process. They write,

"What we learn from the particular experiments reported here is that a common dividend, and common knowledge thereof is insufficient to induce initial common expectations. As we interpret it this is due to agent uncertainty about the behavior of others. With experience, and its lessons in trial-and-error learning, expectations tend ultimately to converge and yield an REM equilibrium."

In other words, individuals believe there is a "greater fool" out there. Perhaps they know that an asset shouldn't be trading so high, but, they buy it on the belief that they can sell it to someone else at an even higher price.

A couple weeks ago I wrote about the Keynsian Beauty Contest game which can be linked to behavior in the Asset Market. Of the Beauty Contest, Richard Thaler writes,

Keynes’s beauty-contest analogy remains an apt description of what money managers do. Many investors call themselves “value managers”, meaning they try to buy stocks that are cheap. Others call themselves “growth managers”, meaning they try to buy stocks that will grow quickly. But of course no one is seeking to buy stocks that are expensive or stocks of companies that will shrink. So what these managers are really trying to do is buy stocks that will go up in value — or, in other words, stocks that they think other investors will later decide should be worth more.

Ride the bubble and trust that there is a lower Level-K reasoner or greater fool out there. As P.T. Barnum is associated with saying, "There's a sucker born every minute."