Irrational Exuberance - Eerily accurate!

You know how a lot of book reviews say "This is a must read!" and of course it's usually hype?  Well in this case, it isn't hype.  With thousands of investment, business or economic books available, why read Irrational Exuberance?  I have never referred to any investment book as "eerily accurate" before, but that's exactly how I'd describe this one.  If you don't read the book, it would be worth reading this summary to get a brief overview.

In 1999 Robert Shiller began writing that the stock market was overvalued, even when the market seemed invincible.  The book hit the shelves in March 2000, which was the peak of the stock market, and by the time it bottomed out in March of 2003 the S&P 500 fell by half after adjusting for inflation.

Then, after watching real estate prices skyrocket for a few years, he thought housing prices could be in a bubble, so he updated his book and in 2005 he published the 2nd edition.  Two years later the real estate bubble burst and we still haven't seen the bottom. 

This is a book about speculative investment bubbles - the factors that contribute to them, and how to spot them.

In hindsight the stock market bubble and real estate bubble seem so obvious.  Why didn't everyone just bail out of stocks and houses?  Why did people keep buying houses even while prices were shooting through the stratosphere?  Shouldn't we have taken notice when banks were giving away free money with no risk via low mortgage rates with 0% down payments?

It turns out, the peak of a bubble is much harder to predict than it appears.  In this book Professor Shiller of Yale University looks at the factors that contributed to the speculative stock bubble of the 90's: 

Structural Factors of Bubbles

Shiller mentions 9 structural factors including:

  • Greenspan's easy money policies which encouraged loose lending standards

  • Low inflation

  • The increase in stock ownership through 401k plans

  • The mentality of the "ownership society" where it was thought that it was good for more Americans to own their own homes.  Employee stock options and employee stock purchase plans are also based on the idea that ownership is fundamentally good.

  • Expansion of stock trading volumes due to discount brokers, day traders and twenty-four-hour trading.

  • An increase in gambling mentality as satellite, cable and internet off-track betting increased, as well as the number of Indian gaming casinos and state lotteries.

  • Amplification mechanisms, or feedback cycles, where the excitement to buy real estate drives up prices quickly, which in turn reinforces the belief that houses are a good investment.

Cultural Factors of Bubbles

  • The influence of news media and the proliferance of financial channels on television.

  • New era economic thinking.  Remember how the dot coms were burning through money and we were expected to look the other way while investing in them?

  • Worldwide spread of ideas.

Psychological Factors of Bubbles

  • Quantitative anchors that have no rational basis, such as "the Dow at 12,000."  He quotes a number of psychology studies that show how people anchor their thinking based on gut feel rather than facts.

  • Moral anchors, mainly centering around storytelling and justification instead of quantitative facts. 

  • Overconfidence.  We humans tend to be overconfident in our own beliefs.  Again citing numerous research studies he shows how easily we are prone to thinking we know more than we actually do.

  • Herd Behaviorand Social Influence.  Of course this is a large factor in driving price bubbles.

What does this mean for you and your portfolio?

Two questions came to mind as I read this book. 

First, "what practical knowledge can we take away from this book?"  Shiller asks a similar question in his concluding chapter:

"When we see such bubble events happening, what should we do about it?  Watching bubbles in the stock market, in the housing market, or in any speculative market is like watching an automobile accident in slow motion.  Is there nothing that can be done?  Actually there are quite a number of things to do."

 

For individuals, he recommends the following:

  • Ensure you are properly diversified in domestic and international stock.
  • If you're overexposed to real estate, downsize your home or structure your investment portfolio to reduce overall exposure to housing-related risks.
  • Increase savings.  We can't rely on stock market growth to fund our retirement needs.  As our country has become wealthier, and our life expectancies increase, our savings rate has actually gone down.

For policymakers he recommends the following:

  • Put company retirement plans on a sounder footing by providing more choices to diversify in stocks and bonds, particularly inflation-indexed government bonds.  Also, provide a way to help 401k participants properly diversify, rather than simply giving them a menu of investments and letting them choose for themselves.  (Willow Ridge Capital Advisors has developed a 401k program to address this issue: Link)

  • Improve Social Security. 

  • Use monetary policy to squelch bubbles by raising interest rates when markets become overheated.

  • Opinion leaders should call the attention of the public when markets are severely overpriced or underpriced.

  • Institutions should encourage constructive trading and develop new methods for the public to hedge their portfolios.

How can you spot a bubble?

The second question that comes to mind is "are we in a bubble today, especially in stocks or gold?" It all comes down to valuations, a word he refers to often.  Stay tuned for my next articles where I will explore the current valuation of the stock market using Shiller's valuation method, as well as the current valuation for gold.