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The greater fool effect outside bubbles

Posted by Graeme in Business & Investment at 9:09 am on Wednesday, 2 May 2012

The greater fool effect is well established as a key mechanism that allows bubbles to inflate to ludicrous valuations: investors who know prices are too high keep buying.  Prices can stay too high in a similar way outside a bubble: not necessarily massively over-valued or in the context of a broader market bubble.

What I have in mind most of all is good short term performance of shares in companies that have long term problems or risks, which do not seem to be reflected in the price. A good example is French Connection which always had potential problems which were likely to manifest themselves sooner or later: most importantly a main brand (FCUK) that relied on shock value which would wear off sooner or later,

However, even though the long term weaknesses were visible in more than a decade ago, the price actually peaked in 2004, when it being evident that the brand was weakening. Anyone taking my advice to sell in 2001 would have missed an opportunity to nearly triple their money.

Why did the market not foresee that the brand would weaken? Were investors too stupid to see what would happen, or too deluded to believe the warnings that it would? I do not think so. As long as there was a good prospect that earnings would continue to grow for a little longer, there was a chance to gain a little more and sell before things went visibly wrong. A greater fool expectation.

Investors also look for catalysts for re-ratings. This is reasonable: you may think a company is on too high or low a valuation multiple, but something needs to happen to persuade the rest of the market of this. If you cannot find such a catalyst then you assume the company will continue to be valued in the same way, so you hold, or avoid buying, until you can see a potential catalyst in the near future.

There is also, of course, an element of herd instinct in this as well: its a bit frightening to sell something that the rest of the market still thinks is worth a high valuation and with good prospects for growing earnings. This is part of what makes it possible to find a greater fool (right up until things fall apart) so it is too closely entwined with the greater fool effect to be regarded as entirely separate.

Investors deviate from investing on fundamentals because of their expectations of what other investors will do, so this itself becomes a key source of market inefficiencies.

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