Irrational Exuberance…Again?

Are we still irrationally exuberant?

One of the most important lessons you can ever learn about markets is also one of the easiest to forget: Just because prices are more reasonable than they were doesn't mean they're reasonable. I'm sorry to report that it's absolutely the lesson to keep in mind now that the Dow has hit 42-year highs and crept back up near 11,000.

The preeminent teacher of that lesson is rob_businessert Shiller, a Yale professor with a strong record of thinking independently and being right. His book Irrational Exuberance, arguing that stock prices were insanely high, appeared almost precisely at their peak in March 2000. Now he has updated the book to reflect 2005 valuations and concludes that, believe it or not, the market is still irrationally exuberant.

How can this be? In part, it's due to a new generation of investors. People like me came of investing age in a time when stocks only went up. But…

As Shiller points out with voluminous support, it just isn't true that stocks always outperform other investments over long-term periods, and, he says, "there is certainly no reason to think they must in the future." If that's true, then stocks would appear to be just as risky as ever. We are not in a "new era." Math still works the same way. And today's valuations are too high.

What Shiller forgets is that people don't know math, and don't care about it. My anecdotal experience would tell me that about 80% of the people I know believe that it's possible to consistently come out ahead by gambling. And about 80% of those people believe they are net ahead for their lifetime.

  • Is there any known connection between investor behavior and Skinner’s variable schedules of reinforcement?

    I know the people who design slot machines are hip to this theory but are the financial services people on it?

  • Rob

    The one and only time I’ve been to Vegas, I remember being astounded at a woman who was playing a slot machine and said to her friend “Oh look! Just a little bit more and I would have had three diamonds.” I kept thinking “yes, but it’s a binary outcome. You win or lose. How close you are is irrelevant.” Somehow I think being close made her want to play again.

  • Jason

    Yes, just try getting an investor to buy an option. It doesn’t matter if you explain that selling an option entails a (theoretically) infinite loss, and your upside is limited. As far as I can tell, only two things matter: 1) I’m recieving cash, not paying it out and 2) My option won’t get excercised. We stink at dealing with pRobabilistic payoffs.

  • I would argue that the latest bubble is being driven more by private investment then in publically traded stocks. Too many baby boomers got burned in the implosion, but a lot of hedge funds are still will to invest massive amounts of capital in pre-IPO companies.

    I don’t think that the term bubble is the best term to use, but there is clearly a lot of interest in these successful privately held companies. I really see this more as the filling of the bubble that we expected back in the late 90’s. At that point people did get ahead of themselves, but the fact of the matter is that there is a technological revolution that is developing from those roots. As companies and hedge funds continue to see success in these private investments, it could translate into the public market, but for now it appears that it’s a private bubble and not a public one.

  • ali

    I agree with the book – however we saw the market increase 3000 points since this post before tanking Oct 2007. How do we justify that? Should we forget about timing and just dollar-cost for life?