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The Greater Fool Theory and Investing

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The greater fool theory (GFT) refers to those who buy an investment based on the premise they will be able to sell it at a profit to a "greater fool." Many investors subscribe to this theory, but don't know they are engaging in it. In an ironic twist, they become the "greater fool," and are left holding the bag when the investment falls and they either can't find a buyer or they have to sell at a loss. Here are some examples of "greater fool" investments. See if you recognize yourself in any of these scenarios:

You Overweight Your Portfolio in Gold

It's clear to you that the world is headed towards a financial crisis that will dwarf the Great Depression. Sovereign debt is out of control. Greece and other European countries are on the brink of bankruptcy. The deficit of the U.S. is at record levels. Something has to give and you believe it will precipitate a world-wide financial meltdown. What's the solution? Buy gold, of course.

You are hoping the price of gold will continue to increase. It better. While you are holding it, it pays no dividends. Gold engages in no productive activity. It is not manufacturing goods or providing services. You should understand that loading up on goal is premised on the GFT. You are assuming that you will be able to sell it in the future to someone whose fear about the state of the world economy is greater than yours. Of course, that's possible. But who was the person or entity that sold you the gold you purchased? They obviously didn't share your world view. Which of you was the greater fool?

You are Picking Stocks

Picking stocks refers to both the practice of buying individual stocks because you believe they are mispriced, or purchasing actively managed stock mutual funds, where the fund manager attempts to beat a designated benchmark. If you are engaging in either of these activities, you are a participant in the GFT.

Individual and institutional stock pickers assume they can find mispriced (typically underpriced) stocks, hold them and sell them at a profit. If anyone could do this, you would think it would be Bruce Berkowitz, the much lauded manager of the Fairholme Fund. With much fanfare, on Jan. 12, 2010, Morningstar issued a press release naming him the "Domestic-Stock Fund Manager of the Decade." It noted this was a new award recognizing fund managers who have achieved superior risk-adjusted results over the past 10 years and have an established record of serving shareholders well."

How did the "Domestic Fund Manager of the Decade" perform in 2011? According to data provided by Morningstar Direct, his fund suffered a staggering loss of 32.4 percent!

Greater fools thought that Berkowitz had the Midas touch that would continue indefinitely. They assumed there would always be buyers at a higher price for stocks picked by him. They were wrong.

If you purchase any actively managed mutual fund, you are engaging in the GFT. One study (reported here) showed the Vanguard Index fund beat 75 percent of designated mutual funds before taxes for the period 1982-1991. The same study found that its after tax return beat 65 out of 71 mutual funds. When you buy these actively managed funds, you are the greater fool.

You Buy a Private Equity Deal

Private equity deals are wonderful profit opportunities for those who manage them. According to the Financial Times, from 2001 to 2010, U.S. pension plans made on average 4.5 percent a year, after fees, from investments in private equity. What percent of gross investment performance was paid in fees to those who managed the funds? Would you believe 70 percent? That's the view of Professor Martijn Cremers of Yale, who was quoted in the Financial Times article.

What if these pension plans dismantled the expensive infrastructure they have in place to evaluate these deals and just invested in passively managed (index) funds, using a balanced portfolio of 60 percent stocks and 40 percent bonds? For the same period of time (Jan. 1, 2001-Dec. 31, 2010), the annualized return of this index portfolio would have been 6.61 percent. You can run your own calculations for the returns of index portfolios for any time period by using this calculator. Use it to compare the returns of your portfolio to an index portfolio of comparable risk.

It will help you determine who is the greater fool.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published December 27, 2011.The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.