When it comes to making money, everyone should be aware of the concept called ‘The Greater Fool Theory’.
Essentially, the theory is that some people buy something purely in the hope that someone (‘The Greater Fool’) will pay more than it's worth in the future.
This is a really important topic as a lot of people play the ‘Greater Fool' game (not really knowing they are playing it or overconfident in winning the game) and end up being the 'Greatest Fool'. As a result, whilst trying to make money quickly, they end up losing it.
When teaching my girls about this concept, I used the stock market as an example.
What have I told my daughters about the stock market before this?
In early 2020 I started speaking to my girls (then aged 5 & 7) about the money we have been investing in the stock market for them. I told them that they own a small bit of thousands of different companies.
We expect that this money invested will grow over the long-term as companies innovate and make more money. For example, McDonalds will create new burgers and open new restaurants, which will help them make more money. As they make more money, we make more money as we own a piece of McDonalds.
Essentially, if you buy a share of McDonalds for $100 and then McDonalds starts making twice as much profit, it would be reasonable to be able to sell that share for $200 to someone else (I appreciate that is very simplified but you get my point).
Companies, as a collective, have always been able to innovate and find new ways to increase their profits. There is no reason to believe that this won’t happen in the future (it would be a depressing world if not) and this is why investing is a good idea.
You can read the full blog on how I introduced the stock market to my kids here
What I hadn’t previously told my girls about is the other reason that people invest in the stock market, the ‘Greater Fool Theory’. Below is how I told them about it.
Teaching my kids about the 'Greater Fool Theory'
To be consistent, I used McDonalds as an example when talking with my daughters.
I got them to pretend one share of McDonalds is worth $100. Then suddenly, people start talking about how McDonalds could change the way we eat in the future
“McDonalds at Home, in the near future you will be able to print a freshly cooked Big Mac in your home using a new special 3-D printer / cooker!”
(Sadly, this is just something I made up rather than being actual gossip).
People hear the news about the new ‘McDonalds at Home’ and believe McDonalds will make loads more money in the future.
The price of one share of McDonalds jumps from $100 to $200. Then the next day as the excitement builds it jumps to $400.
People who own shares in McDonalds are starting to get rich quick! Other people hear the news that people are getting rich by buying shares in McDonalds, and want to buy them too.
News comes out that a famous billionaire buys loads of 3-D printers as they see printed food as the future. This drives more people to get excited about what McDonalds might be planning. The next day, the price jumps to $1,000.
Everyone is now going crazy and wanting to get rich from owning shares in McDonalds. They say "Wow, if I buy a share now at $1,000 and sell it to someone else (a ‘greater fool’) for $2,000 in the future, then I'll be rich just like everyone else!”
Remember, the news about ‘McDonalds at Home’ is still just an idea. They haven't actually made any money from this. Their profit is still the same as it was before. No one knows if McDonalds is actually going to make more money from this and how much money they might make. People just hope that this great idea happens and people will continue to want to buy shares in McDonalds in the hope of selling them to someone else for more money in the future.
The Greatest Fool
Suddenly, the person who buys a share of McDonalds at $1,000 waits for the price to go up but it doesn’t go up any more. There are no 'greater fools' who believe it will be worth more than $1,000. This person is ‘The Greatest Fool’.
Everyone who bought a share in McDonalds with the hope of selling it to someone else based on the news starts to worry. Everyone knows that there aren’t any more ‘fools’ left to sell their shares to at a high price.
At this point everyone starts to question, what is McDonalds ‘actually worth’? Is it worth 10 times more than what it was just a few days ago?
As people realize they can’t answer these questions, they get scared that it could be worth a lot less than they paid for it. They try to sell their shares before other ‘fools’ do. The price of McDonalds shares drops quickly and lots of people who bought shares in McDonalds lose a lot of money.
My eldest then said “This sounds like ‘gambling’”. Her words, not mine (I know this is a sensitive topic for a lot of people!).
Key learnings for my girls
When lots of people are playing the ‘Greater Fool' game, it’s so hard to not get caught up in the excitement. “It’s going to the moon! 🚀🚀🚀”
I then explained that ‘The Greater Fool Theory’ doesn’t just apply to the stock market. It applies to most things that people buy with the hope of making more money in the future. This could include fine art, Bitcoin (and other cryptocurrencies), gold and property.
As my girls grow up they will hear lots of stories of people making a lot of money quickly as they are in the middle of a ‘Greater Fool' game. I want them to be aware of what’s going on (as many people don’t realise, or at least don’t admit, they are playing the ‘greater fool game’).
I want my girls to be patient with their money and think long-term. This means ignoring the hype and not caring about what money other people are making (or losing).
My view on Bitcoin
I get asked for my view on Bitcoin quite a bit, so here’s my two-cents.
I personally know a lot of people who are taking a risk on Bitcoin and doing very well out of this. Kudos to them for taking the risk and reaping the rewards. It’s just not for me.
I like the idea of Bitcoin as a concept (digital currency which isn't controlled by a central power) but I have no idea what is a good price to pay for it. At the moment I know too many people who are openly using it as they are playing the ‘Greater Fool’ game (although they don’t call it that) which leads me to think that the price today is detached from the ‘fair value’ (whatever that may be). There are other reasons why I'm not investing in Bitcoin and they are largely aligned to those set out by Dan (The Financial Wilderness) in his blog here.
I could be wrong. Bitcoin could continue to be worth a lot more money in the future. That’s fine with me as it may be worth a lot less, or even worthless, in the future. I just don’t know and I don't want to be the ‘Greatest Fool’!
The ‘Greater Fool Theory’ is a dangerous game to play. By definition, there is a risk that you become the greatest fool and lose a lot of money.
Whilst there are a lot of people using the stock market to play the ‘Greater Fool' game, this just creates noise and opportunities for those who are investing for the long term based on a belief that companies (as a collective) will make more profit from continued innovation.
One financial superpower I’m very keen for my kids to learn is:
‘Don’t compare your own financial situation to that of others'.
When friends, social media and celebrities are all talking about it, it is hard to ignore but the right thing to do over the long-term is to ignore it.
If you haven’t already, I’d recommend you check out my blog on 'How to teach your kids the stock market'
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