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.

7 thoughts on “The Greater Fool Theory”

  1. Austin says:

    So when do you expect the bubble to pop? 1year? 5years? 10years? I am starting to get into the process of finding out what it takes to purchase a house within the next year or two and I was wondering if it would be wise to wait until the bubble pops?

    Also I just wanted to say that your posts really have helped me out and are VERY informative. Keep it up!

  2. John Chow says:

    If I knew when the bubble will burst I’ll be super rich! 😀

    If you’re buying a house to live in and not as an investment then timing really doesn’t enter the equation – you have to live somewhere. Your decision to buy or not should be based on your current financial situation and not on what the market is doing. If you do that, you’ll never buy anything.

  3. Marco says:

    People say its a bubble but I think its just part of the boom/bust cycle that economies tend to go through…

  4. Steve says:

    My dad and I own a large manufacturing company that builds components for houses with 5 locations on the west coast. Single Family Homes are not looking very pretty now. Most of our customers are 50% of last year. I’d sit tight for at least 1 year anywhere on the west coast.

  5. Jan says:

    BC will be fine especially places like the okanagan that attract baby boomers by the fistful. As the population ages in Canada boomers don’t want to live in extreme winter climate and only lower bc can offer them that. While I don’t think we’ll see the growth we have the last three years, I also highly doubt any significant declines.

  6. Lawrence says:

    Home Depot has been reporting slower sales…. that could be a good indicator.

  7. Michael Zou says:

    I don’t know if Option ARM (Adjustable Rate Mortgage) is availible in Canada but in the States many first time home owners are using Option ARM to finance their homes. Option ARM is a mortgage that enables home owners to pay low interest minimum payment for the first few years then pay a higher interest when the mortgage resets on top of the interest difference that was compounded from paying low interest in the beginning. Little did they know a $2000 montly payment in the beginning period can readjust to $3500 when the mortgage resets. A high percentage of American home owners (12.3% through the first five months of 2006) that are not interest/finance savvy already bought option ARM to finance their homes. This will only lead to a bigger burst More than ever in history, more Americans will default on their mortgages. God bless all the home purchasers that used option ARM.


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