Beware The Greater Fool

Early in my investing career I was told a story that illustrated the concept of ‘the greater fool‘. It’s remained front and centre in my mind ever since and given the irrational behaviour of the Aussie property market, I feel it’s prudent to tell you about it as forewarned is forearmed.

The story told to me is an account of how, in the midst of the roaring (19) 20?s, a stockbroker left his desk in a stockbroking firm on Wall Street and caught the lift to the ground floor, possibly to make a lunch appointment with a colleague.

As he got into the lift he overheard two busboys, lower paid young men whose job it was to operate the lift, talking about how they had invested in stocks and made quick profits.

After hearing the tales of easy money and gossip of hot stocks, he immediately went back to his desk and sold down his share portfolio.

For many months later his peers scoffed at him for selling too early and missing out on higher profits as the market went higher and higher still.

But then the crash came, and with it much wealth evaporated.

When asked later how he managed to exit before the crash that sparked the Great Depression unfolded, the broker said that when he heard the busboys talking he realised that instead of operating on the back of solid economic fundamentals, the stock market was being bid up by irrational speculators.

Without understanding what they were doing, or exactly how the company they were investing in was going to make money, fool investors relied on another (greater) fool to come along and bid up the stock in order to drive the price higher.

The market peaks when the greatest fool buys. That is, there is no greater fool willing to pay a higher price than the fool who had just bought. Once that happens a crash is imminent.

(If you want to learn more about this concept then Google ‘greater fool theory’.)

The reason I’m retelling this story now is that I’m becoming more and more concerned with what I’m reading in the papers about record property prices and irrational behaviour at auctions.

Bluntly, how many greater fools can there be?

These record prices are not supported by the current or expected performance of our economy, job prospects, or rental yields. Surely we are in fool territory where values are being bid up on the belief that prices cannot, and will not, fall. This is simply wrong.

Consider Moranbah in Queensland. Rents for a 3 bedroom home in March 2012 were a whopping $2,000 a week. Attracted by high returns, median house prices rocketed up to $710,000 as investors outbid each other to get a slice of the positive cash flow action (median house prices in March 2009 were $176,435). It was happy days indeed.

Then the mining boom ended, and as jobs were shed, rents fell as housing supply exceeded demand. Prices followed and today a 4 bedroom home rents for $340 a week and the median house price is $372,000.

The principle here is that any housing market characterised by more investors than home owners runs the risk of a sudden price collapse when the reason for investors being attracted to that property ends causing them to need to exit quickly.

That is, if investors cannot afford to hold the property then supply can suddenly increase as properties are offloaded, and if there are not a sufficient number of buyers (which there won’t be if the majority of buyers were investors in the first place), then price can fall, fast as sellers compete to exit by slashing prices.

In respect to Moranbah it was the high rents that ended as the job market softened and vacancies increased, but the same holds true in respect to the removal of tax incentives (beware NRAS investors), or the removal of tax concessions (beware heavily negatively geared investors)..

Rarely do you see the reason for the change in conditions coming, but you will certainly feel the nasty effects of being caught up in a whirlwind downturn.

(As a side note I have to note that several prominent hot spotting sprinklers advocated buying in towns like Moranbah and have quickly moved on to other areas and have hushed up their failed projections, whereas investors who followed their advice are left with the nasty consequences.)

So the message is simple…

Don’t be fooled by the record prices being reported in the papers. Without the required economic strength to back it up, it’s shaping up to be more mania than genuine money making opportunity.

As I have said before, it is always a great time to buy a great property, but it’s fast becoming an awful time to buy a dud. Let the buyer beware.

So, enough from me… what do you think will happen to property prices over the next 12 months? Share your thoughts by leaving a comment below. I’d also love to hear the good, bad, and the ugly if you went to a seminar and were advised to purchase in mining areas.

And now for something a little more lighthearted…

A central banker walks into an Italian restaurant to order a pizza.

When the pizza is done, he goes up to the counter to get it. There the shop owner asks him: “Should I cut it into six or eight pieces?”

The central banker replies: “I’m feeling rather hungry right now. You’d better cut it into eight pieces.

I’m off on a short vacation in Tassie. Until we speak again, stay safe and remember that success comes from doing things differently.

Steve McKnight


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