All middle-class investors should read Robert Shiller’s book on Irrational Exuberance. It tells us things about how stocks work that are rarely reported on by less informed or less objective or less courageous investing analysts. This article provides a “cheat sheet” to the most important of Shiller’s insights for those who don’t have time to read the book.
The first thing that you must know about Irrational Exuberance is that the rationalizations that are used to argue that today’s bull market prices are not a cause for alarm are nothing new.
George Gibson argued in a book published in 1889 that, when “shares become publicly known in an open market, the value which they acquire may be regarded as the judgment of the best intelligence concerning them.” That’s essentially the “insight” that is today referred to by defenders of bull market excesses as the “Efficient Market Theory.”
It’s not really an insight, it’s a rationalization. People who believe in the Efficient Market Theory don’t believe in it because the historical stock-return data makes a strong case for it. The data makes a strong case that the primary influence on prices is emotion, not reason.
And it’s not that some Big Brains have in recent decades discovered something that nobody knew about before. Those who believe do so because they want to believe. Confidence in the Efficient Market Theory is achieved by an act of will.
It was the same story in the days before The Great Crash. Here are some words put forward by Joseph Lawrence in 1929: “The consensus of judgment of the millions whose valuations function on that admirable market, the Stock Exchange, is that stocks are not at present over-valued…. Where is that group of men with all-embracing wisdom which will entitle them to veto the judgment of the intelligent multitude?”
People have been cooking up rationalizations for investing in overpriced stocks since the first stock market opened for business. The important thing to know about such theories is that confidence in them crashes along with prices in the wild bear markets that always follow wild bull markets.
The second thing you must know about Irrational Exuberance is that those who follow more sensible investing theories do not believe that it is possible to make gobs of quick money by knowing that stocks are overpriced.
Defenders of the bull market excesses often paint cartoonish portraits of those who reject the Efficient Market Theory. They suggest that, if the market were not efficient, it would be possible to get rich quick simply by investing in a valuation-informed manner. It’s not so.
Here’s what Shiller says: “If indeed one knew today that the market would do poorly over the next 10 or 20 years, but did not know exactly when it would begin to do poorly…there would be no way to profit significantly from this knowledge.”
Looking at how valuations have affected long-term returns in the past permits you to protect yourself from the worst effects of bull market excesses and to obtain stronger value propositions from your investing dollars. But Valuation-Informed Indexing is no Get Rich Quick scheme.
Valuation-Informed Investing is common-sense investing. It stands a good chance of paying off in the long run. Its most ardent supporters don’t claim that it does more than that.
The third thing you must know about Irrational Exuberance is that there is lots of academic research pointing out the holes in the Efficient Market Theory.
Shiller explains on page 179 that: “There is no shortage of systematic evidence that firms that are ‘overpriced’ by conventional measures have indeed tended to do poorly afterward. Many articles in academic finance journals show this, not by colorful examples but by systematic evaluation of large amounts of data on many firms.”
Please don’t be taken in by silly and misleading claims that “everyone knows that” the stock market is efficient. It is common practice for lots of people to say such things during wild bull markets. If lots of people did not say such things during wild bull markets, wild bull markets could not remain in place for long. But it is false to say that “everyone knows that” markets are efficient. There are many knowledgeable people who have seen through the rationalizations of the bull market excesses that have become popular in recent years (this article was written in October 2006).
The fourth thing you must know about Irrational Exuberance is that the pain that we are in all likelihood going to experience as a result of the bull market excesses could be severe indeed.
The loses that investors are likely to suffer as stock prices make their way back down to reasonable levels “could be comparable to the total destruction of all the schools in the country, of all the farms in the country, or possibly even all the homes in the country,” according to Shiller.
Not good.
The fifth thing that you need to know about Irrational Exuberance is that the blame for this pain is properly placed not on the average investor but on the “experts” who failed to warn us of the risks of getting carried away by our emotions and who in many cases actually encouraged us to get carried away.
I have many times during The Great Safe Withdrawal Rate Debate had conversations with middle-class investors who sense that they are not being told the straight story about the dangers of stock investing today and who are seeking the pieces of the puzzle missing from the story being told by those who defend the bull market excesses.
Some of the people identified as “experts” simply do not know any better. Others do, but fail to speak up because they know they will be criticized by defensive extremists. I am not without sympathy. I doubt that there is anyone alive today who knows better than I how vicious those who defend the bull market excesses can be when hard questions are posed to them about their claims. Still, I think it is shameful for those who know about at least some of the holes in the now-popular rationalizations to fail to speak up about what they know. It is the job of a stock analyst to share with the public what he or she knows about how stocks work, whether the information shared happens to make most people who hear it pleased with the analyst or not.
I strongly endorse Shiller’s argument that: “The market is high because of the combined effect of indifferent thinking by millions of people, very few of whom feel the need to perform careful research on the long-term investment value of the aggregate stock market, and who are motivated substantially by their own emotions, random attentions, and perceptions of conventional wisdom.”
Those who put themselves forward as “experts” must be held to a higher standard than the typical investor, who has fifty claims being put on his or her time on a daily basis. Most investors of today are placing their trust in the experts to tell it at least reasonably straight and most of the experts are letting them down. As Shiller says, “It is a serious mistake for public figures to acquiesce in the stock market valuations we have seen recently, to remain silent about the implications of such high valuations, and to leave all commentary to the market analysts who specialize in the nearly impossible task of forecasting the market over the short term and who share interests with investment banks or brokerage firms.”
Wake up, stock experts!
The sixth thing you must know about Irrational Exuberance is that the media is generally not a reliable source of investment insights.
The media likes to focus on continuing stories that regularly produce new fodder for media discussion. The stock market is a great topic because it produces fresh “news” on a daily basis.
That’s so when you understand stock investing only on a surface level. It is not true when you develop an informed understanding of how stocks work. The daily price changes are pointless noise. The media focus on the part of the story that matters least (the daily price changes) and ignore the story that matters most (the long-term risks to middle-class wealth presented by today’s valuation levels).
Shiller observes that: “Sometimes the article is so completely devoid of genuine thought about the reasons for the bull market and the context for considering it that it is hard to believe that the writer was other than cynical in his or her approach.” Precisely so.
I feel a need to add that it is not necessarily the reporters who are cynical. Reporters need to write what their editors tell them to write and editors need to instruct their reporters to write what their publishers want to see appear in the paper. I made a living as a corporate journalist for many years. My primary goal in seeking financial freedom early in life was to be able to provide in the articles I write the context readers need to derive a significant benefit from reading them.
Don’t count on the media to do your homework for you. Don’t count on a stock broker to do your homework for you. Don’t count on big-name experts to do your homework for you. Pick up a copy of Irrational Exuberance and begin the project of educating yourself as to how stocks really work.
The seventh thing that you need to know about Irrational Exuberance is that it is not possible to prove beyond any doubt that the stock market is not efficient.
It is one thing to say that there is a lot of historical data showing that the market is not efficient. It is something else again to say that we can prove beyond any doubt that the market is not efficient. As Shiller observes, it is often all but impossible to prove a negative.
Given how risky an asset class stocks are, and given how much it increases the risks of stock ownership for middle-class investors to come to believe that the market is efficient, the burden should be on those arguing that the markets are efficient to make their case, not on those pointing to the evidence showing that they are not to prove that it is so.
One of the arguments that has been advanced to get discussion of the Valuation-Informed Indexing approach banned at a number of discussion boards is that it is “dangerous” for people to be able to hear the counter to the claims of those arguing for the Efficient Market Theory. I see it just the other way around. Stocks are a risky asset class. Those arguing that investors should not give serious consideration to the risks that go with owning stocks present more of a danger than those arguing that investors should take a look at the historical stock-return data before putting too high a percentage of their portfolio in overpriced stocks. We are living in Humpty Dumpty World when it is viewed as “dangerous” to allow discussion of the risks of a high-risk asset class at a time when the risk attached to investing in it is at its highest level in history.
The eighth thing that you need to know about Irrational Exuberance is that most stock investors hold contradictory views about how stocks work.
As part of an explanation that compares how Ponzi schemes become credible in the eyes of many of the people invested in them and how overvalued stock markets come to be seen as not too dangerous in the eyes of many of the people invested in them, Shiller observes: “That others have made a lot of money appears to many people as the most persuasive evidence in support of the investment story associated with the Ponzi scheme–evidence that outweighs even the most carefully reasoned argument against the story.”
If I had five dollars for every time a poster at a discussion board participating in The Great Safe Withdrawal Rate Debate said in response to a hard question about what the historical stock-return data really says that “I’ve made a whole bunch of money investing in stocks, buddy, why should I listen to anything you have to say on the topic?” I would be able to afford to take my kids to Disney World for a month. Humans are inclined to trust real-world results above theory. With both Ponzi schemes and bull markets, the real world results are solid.
Until the day comes when they are not.
Why it is that people cannot see through the illusions in time to save themselves from taking a big financial hit? One big reason is that “people have learned that when experts tell them something is all right, it probably is, even if it does not seem so.” Another is that “in everyday living we have learned that when a large group of people is unanimous in its judgment on a question of simple fact, the members of that group are almost certainly right.”
Please note that the fact that other investors have confidence in stocks and the fact that many experts have confidence in stocks are not reasons for ignoring valuations. Human beings are not computer with legs. Our actions are not motivated only by reasons. They are motivated by feelings too. Investing is primarily an emotional endeavor, and only secondarily a rational one.
The ninth thing you must know about Irrational Exuberance is that most stock investors do not hold their beliefs about stocks with much conviction.
Things won’t change because people come to see the illogic of their beliefs. What impresses people about stocks in a positive way is seeing people make money by investing in stocks. What will impress people about stocks in a negative way is seeing people lose money by investing in stocks. The cure for irrational exuberance is the widespread suffering of huge financial setbacks. There’s no other way to get from where we are to where we want to be.
How is it that people will give up their belief in the Efficient Market Theory and all that other jizz-jazz? That one’s easy. Few people ever believed in that sort of thing anyway. People say they believe in it because they feel a need to say something when questioned about their behavior. The Efficient Market Theory is a rationalization that comes after the decision to invest in stocks (a decision that results from the observation that lots of other people have made money doing so) has been reached.
Here’s how Shiller puts it:
“People widely believe that the stock market is unforecastable and that market timing is futile. But they also believe that, if the stock market were to crash, it would surely come back up. Such views are clearly inconsistent…. People do not much worry about the apparent contradictions among the views they hold. There is a willingness to free ride here — to suppose that the experts have thought through the apparent contradictions and therefore to assume that the experts know why they are not in fact contradictions at all…. People’s thinking about the arcane field of investments is surely clouded with many half-thought-through ideas that may be mutually contradictory, or at least have not been put into any coherent analytical framework.
Get ready for the clincher.
“The significance of the fact that contradictory views are held simultaneously is that people have no clear attachment to many of their views. Therefore we cannot attach too much credence to investors’ stated belief that the market will surely come back after a crash, for the circumstances of the actual crash could bring to the forefront other, contradictory views that would explain away a lack of market resilience. Investors would then react in ways that could not have been foreseen based on their previously expressed confidence.
The tenth thing you must know about Irrational Exuberance is that the Indexing Revolution may have made things worse.
The increased popularity of investing through indexes and mutual funds rather than through the purchase of individual stocks has in some ways made stock investing more emotional (while in some other ways making it less emotional). For stock investing to be rational, investors need to be informing themselves of the economic realities of their investment choices. For those investing in individual companies, the need to do this is obvious. For those investing in indexes or funds, it is not so obvious. People are tempted “not to, as they see it, waste their time and effort in exercising their judgment about the market” since they believe that they can count on the experts who keep the market efficient to do the job for them.
I see indexing as a plus. But I think it has made investing too abstract an enterprise for many investors. Indexers tend to lose sight of the economic realities that generate the profits on their investments because they are not required to engage in independent study of them.