Greater Fool Theory - Is Bitcoin a good idea for your portfolio... or not?

"Greater Fool Theory" is the name given to the idea that you only buy something with the hope that someone pays more for it in the future. Since the Bitcoin investment craze has come about, many serious investors including Warren Buffett and Bill Gates have started talking about cryptocurrencies in terms of the Greater Fool Theory.

"Surely hoping for someone else to buy your asset for more than you paid for it is common to all investments" you ask? Well sort of... but only to a certain extent.

At RetireOnDividends, we focus on buying PRODUCTIVE assets and we hope you will too. This means the underlying asset actually throws off an income for you each year.

Assets such as stocks which, after all, are part of a business should pay you dividends over time. Bonds and cash pay you interest. Property pays you rent. This ability to produce gives the asset some intrinsic value and as a result you can make a good return no matter what the price of the asset does.

If you buy assets that DO NOT produce anything, then you're relying on the next buyer to pay a higher price when you sell in order to make a return.  And as the asset is not producing anything at that point either, you are effectively searching for a "Greater Fool".

Which types of investments are dependent on the "Greater Fool Theory" to go up in value?

Typically the following:

  • Bitcoin and other cryptocurrencies
  • Gold
  • vintage cars
  • fine art
  • wine
  • antiques. 

Price increases on these "assets" are entirely at the mercy of sentiment towards them at the time you wish to sell. If people believe they can sell them on at a further profit, you may well be able to make money, but sooner or later this kind of speculative bubble is likely to burst.

Are there other tell-tale signs that I'm getting into a "Greater Fool Theory" investment?

As Warren Buffett puts it in the following video, "all you're hoping for when you buy a non-productive asset is that you'll be more excited about it when I want to sell it than I am... but when you buy a productive asset, buy the time you come to sell it you've got not just what you bought in the first place, but you've had some significant income from it in the meantime".

"Should I buy bitcoin? Should I buy Gold?" 

These are questions I often get asked and the problem with both these investments that you are completely reliant on  the sentiment in the market when you want to sell. 

This is the greater fool idea in practice: in order to profit you need a "greater fool" to buy your asset from you. Instead of this, we recommend you should focus on assets that produce for you. 

An interesting question to ask yourself in order to see whether you're falling foul of the "Greater Fool Theory" is to consider how you'd be affected if the market closed and you couldn't sell your asset for an extended period? 

This may sound far fetched but the market did close for around six months in 1914 (and some international markets a lot longer). If you owned a portfolio of high quality stocks and interest producing assets, this should not concern you as you would continue to benefit from the earnings and dividends.

But if you've have fallen for the greater fool theory then you are far more likely to be stressed out by your "investments" if the market should shut in this manner. 

You will also be concerned / offended if people short your investment or talk it down. This is because you need the price to go up, you have no other value in your investment! You will probably be checking the price of your holding every 5 minutes and could panic if it starts falling.

If you have bought an asset with intrinsic value derived from some form of pay out, then you won't have such worries. 

If you bought a farm you'd probably do so to derive income from the crops produced. You wouldn't dream of calling up a real estate broker a week after you bought it and ask for a quote on the whole farm. After twenty or thirty years, you would have received the earnings off those crops during that time and the farm should still be worth something depending on the ongoing earning ability of that farm. 

If you buy an asset and wonder whether it will go up next week, next month or even next year then you are falling for the greater fool theory. You are simply speculating rather than investing in the market which is really far closer to gambling than investing. 

It's important that value investors know the distinction between investing and speculating and you avoid falling for the greater fool theory when making investments.

Mike - 6-figure dividend earner

For another take on Greater Fool Theory, click here

Mike - six-figure dividend earner

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