Robert J. Shiller’s book examines the effect of irrationality on financial markets and asset pricing
By Narayan Sharalaya
Coined after Alan Greenspan’s famous speech in 1996, Irrational Exuberance by Robert Shiller correctly predicted the 2000 and 2005 stock market and housing bubbles that were to occur. In the third edition of this book, the author explains the factors behind over-valuation and pricing with empirical data of previous stock market crashes and housing bubbles. The book analyses specifically the structural, cultural and psychological factors behind them and suggests methods to prevent future bubbles that are bound to occur.
Structural Factors and Amplifying Mechanisms
Certain factors lie outside of markets yet affect pricing in a non-rational ways; the book identifies twelve such precipitating ‘structural factors’ that together lead to a collapse. These vary from the capitalist explosion to technological advancements or even the growth of mutual funds.
The book also argues that there exist certain ‘amplifying mechanisms’ that intensify the effects of these structural factors. These are identified as
- Changes in investor attitudes towards stocks as a long term investment that could not go wrong.
- Increased public attention towards stock markets leading to more money being available for stocks.
- The feedback loop which keeps stock prices high as people invest more in the markets upon hearing of its good performance.
The book identifies two cultural factors that affect the financial and housing markets. The first one being news media reports on stock markets during periods of booms and busts. News stories have often contributed to the psychological feedback loop and contribute towards asset prices. The role of news media on the stock market highs of 1920, 1970 and 2000 have been studied and explained.
The second cultural factor that explains over valued markets is the opportunism of new era economic thinking. This is an old phenomenon that has existed since the 1900’s when railroads and increased industrialisation led to optimism in the financial markets that was unjustified. New era thinking has dominated many periods of over priced markets with the most recent one being the technological boom that raised the prices of many internet companies.
Cognitive biases in decision making play a huge role in the stock market. Overconfidence, anchoring, and availability all play a role in investor decisions. Herd behaviour and the need to conform cause other investors to make similar decisions in the market.
Containing Speculative Volatility in Free Society
The book ends with suggestive measures to prevent future speculative bubbles from taking place. The author stresses on the need to curb the phenomena of economic bubbles as it is the poor and middle class who are affected the most during a stock market crash. A gentler monetary policy during stock market highs, stabilising opinions by leaders, a restructuring of savings and social security schemes, better risk management, and diversified portfolios are some of the measures suggested.
With behavioural finance gaining steam in today’s world, the book perfectly captures investor sentiments and thinking during times of highs and lows. It is now to be seen whether these can be incorporated into models that play an active role in public policy. Until then, ensuring better social insurance and more effective financial institutions to manage risk is necessary to prevent future volatility.
Narayan Sharalaya is an intern at Takshashila Institution and is currently doing his Bachelors in Economics at NMIMS, Mumbai