The Greater Fool Theory: Does it apply to house purchases in the last couple of years?

There’s a stock market theory I remember talking about during the 2000-1 dot com boom, (I can’t remember who first told me a version of it) when I was on Simply Money TV. Over the last couple of years or so I’ve mentioned it when chatting about house prices to various friends, so I thought it worth a muse here.

It’s called the “Greater Fool” theory, and it happens when people buy assets at a value higher than they can realistically justify, in the belief that the market will continue to rise.

House Price Rises

Over the past five years, I’ve lost track of how many people I’ve heard say something akin to “I can’t believe I have to pay £230,000 for a one bedroom flat in the centre of XXXXXX, it’s ridiculous, but that’s the market.”

Effectively, this is buying a property where you simply feel the price isn’t justified, but as it’s the price, you go for it anyway on the assumption of continued rising values.

The Greater Fool Theory

What the theory does is crystallise the logic being used in the buying price. It says:

I believe the current price is too high, but I’m buying it in the hope a ‘greater fool than me’ will be willing to pay even more for it in the future.

The key GF theory hope is that you’re not the “Last Fool”. If you are, and buy just before the market crashes, you end up losing horribly.

Sadly all those who bought a home between six and eighteen months ago, thinking they’d only keep it for a couple of years, may be the ones to qualify in the recent house market bubble.

That isn’t an implied criticism. The same could’ve happened to those who bought the year or two or three before. The house price crash fraternity have been calling the market down for a good number of years and those who bought in the early days are still heavily in profit.

The key problem here is that knowing EXACTLY when the market will turn is difficult. It’s the reason why I’ve always said I expected house prices to crash and houses were overvalued, but I had no clue as to when… 1 year, 3, 5, 50? (e.g. see Squaring the house price circle blog, Property porn experts: where are you? blog, The Four Horsemen of the financial Apocalypse blog). My conclusion was that for those who are risk averse, the key defences are to ensure you don’t overstretch yourself when getting a property, buy for the longer term, and check you can easily cover the mortgage even if interest rates were to rise by three percentage points.

Now my hope is there aren’t too many ‘last fools’ who will really hurt; affordability is still a crucial criteria. While it’s galling and ugly to be locked into a mortgage for a property that is decreasing in value, or worse moving into negative equity, affordability at least prevents repossession (if you are facing repossession see the Debt Help guide).

So does the greater fool theory apply to residential property?

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