The greater fool theory: A mostly verbal mathematical model of price bubbles

Introduction (Via Gene Expression)

Here is a brief description of the idea that price bubbles are caused by people buying something, not necessarily because they think it’s worth anything, but because they think they can find an even greater fool to buy it at a higher price. This continues until no more such fools can be found, and this bust drives prices back down to what they were before the boom began.

Excerpts (Via Gene Expression)

First, we set up the basic picture before we write down equations. My version of the greater fool theory goes like this. There is a population of people, and during a price bubble they can fall into three mutually exclusive groups: suckers (S), who are susceptible to joining in on the bubble; investors (I), who currently own the speculative stuff (such as a home bought for speculation); and those who are retired from the bubble (R), who used to be investors but have gotten rid of their investment. And of course there is the price of the thing — I model only the extra price that it enjoys due to hype (P), above its fundamental value, since this is the only component of price that changes radically during the bubble.

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About Miguel Barbosa

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22. August 2009 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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