I hear a lot about the "Greater Fool Theory." Can you explain it to me?

A reader asks: I hear a lot about the “Greater Fool Theory.” Can you explain it to me?

Archer replies: In the 1991 movie “The Addams Family,” Raul Julia plays family patriarch Gomez Addams. His wife, Morticia, is the estimable Anjelica Huston, daughter of the director John Huston (“The Maltese Falcon,” “Treasure of Sierra Madre”).

The plot is kind of cobbled together, driven by filial love, with a prodigal son overlay. There is a scene where Gomez is hit with a restraining order by his lawyer, Tully, banning him from the family manse. Gomez then decides to represent himself at court, declaiming to all and sundry, “They say that a man who is his own lawyer has a fool for a client … I am that fool!”

So in this case it’s obvious who is playing the role of the naïf. But in the real world that often is clear only ex post facto, to continue in a legal vein. Back in the 1980s I was walking along St. Mark’s Place in New York’s East Village. There was a young man standing on the corner in front of the decidedly downmarket St. Mark’s Hotel holding a sign. “Please give me some money for no discernable reason,” it said. I gave him some money.

The Greater Fool Theory operates in a similar fashion. You buy bitcoin at $60,000, or GameStop shares at $80, not because you think they’re cheap but because you think someone else will come along and, for no discernable reason, pay more. Sometimes it happens. That person is, by definition, the “greater fool.”

The Wall Street Journal recently ran a story on the growing use of short-dated options by retail investors. Many of those interviewed admitted to losing thousands of dollars. Fine. Caveat emptor.

Bloomberg’s Matt Levine weighed in on the piece, writing: “There is a quote from an academic with the standard criticism: ‘We should stop pretending that’s what’s going on is investing,’ said Benjamin Edwards,a professor at the University of Nevada in Las Vegas who has studied securities law. ‘It’s just gambling.’

“But in fact nobody is pretending! (writes Levine). Everyone interviewed in the article is like ‘oh yes this is my fun gambling hobby.’”

It’s a risky strategy, however. The Journal cites a study by the London Business School that estimated that most individual options traders lose money – as much as $2.1 billion from November 2019 to June 2021, with the losses concentrated in shorter-dated trades.

A somewhat separate, but not irrelevant point, is this: due to the “vig” or “vigorish” the game is heavily weighted in favor of the house. Bid and ask spreads are typically wider on options trades. Someone is collecting that difference, and it’s not the customers. The higher the costs the higher the win rate you need to overcome them; at a 10% vig you need to win 52.4% of the time just to break even.

There is, of course, a more conventional form of betting on rising (or falling) prices: momentum investing. The idea here is that price trends tend to persist, both on the upside and the down. This has been written about by, among others, Burton Malkiel, in his classic A Random Walk Down Wall Street and there does seem to be some evidence for it. Malkiel is not recommending momentum as a strategy, however; he is an unabashed fan of something a little lower on the adrenaline scale — broad-market index-based strategies. This is, as Levine puts it, a “sensible form of long-term investing (that) is pretty dull.”

Still, for most of us making money slowly is better than losing money quickly. The temptation to gamble will always be there, the greater fool may not be.

Woof.