Irrational Exuberance by Robert Shiller

Summary

An attempt to explain booms and busts in financial markets. Long-winded, boring and there is a danger to become oblivious to the real causes: leverage and human psychology. Read A Short History Of Financial Euphoria instead.

Key Takeaways

• Roughly half of the variability of home prices can be predicted one year ahead.
• From 1628 to 1973 the Herengracht annual real price increase was only 0.2%. Real home prices did roughly double but took nearly 350 years to do so.
• It is curious that people do not seem to believe the converse of the premise stated in our question: they do not believe that the market will surely go back down in a couple of years if it goes up dramatically.
• Regret is an emotion that, psychologists have found, provides considerable motivation.
• 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.
• The media actively shape public attention and categories of thought, and they create the environment in which the speculative market events we see are played out.
• Nonconsequentialist reasoning: reasoning that is characterized by an inability to think through the elementary conclusions one would draw in the future if hypothetical events were to occur. People cannot decide until the events actually occur.

What I got out of it

Very boring to read. A 300+ page academic paper. It could’ve easily been written in fewer than 30 pages. One of the few books thus far I ended up skimming through; reading the first and last page of every chapter sufficed.

“The least important questions are the ones most emphasized: What triggered the crash? Were there some special factors that made it so dramatic or drastic? Who should be punished?” – A Short History Of Financial Euphoria

Robert Shiller made an admirable attempt to try and explain the markets. 

But rather than read something that tries to explain an extremely complex situation or system – like the financial markets – with the danger of thinking “I know it all” and becoming oblivious to factors not mentioned in Irrational Exuberance, I feel there is more value in reading books that simply recount the history of such exuberance. 

What ultimately causes irrational exuberance is simple: human folly and all our psychological imperfections.

Robert Shiller himself sums up my critique of Irrational Exuberance best: “Many of the factors that led to these booms had a self-fulfilling aspect to them, and they are thus difficult, if not impossible, to capture in predictive scientific explanations.”

Summary Notes

The Bond Market In Historical Perspective

It is one of the puzzles of behavioural economics that people mostly just ignore inflation-indexed markets – that they have so much trouble appreciating the importance of inflation indexation.

The Real Estate Market In Historical Perspective

The profit opportunities for buying at the right time are just not available in the smart money that operates in the stock market because of the costs of getting in and out of the housing market. It is not easy for most people to time the purchase of their homes to take advantage of trends.

Our statistical studies of forecasting models for home prices show that roughly half of the variability of home prices can be predicted one year ahead.

When this index [of houses along the Herengracht, Amsterdam, from 1628 to 1973] is corrected for inflation over this whole period, we see that there was not much overall home price increase. From 1628 to 1973 the Herengracht annual real price increase was only 0.2%. Real home prices did roughly double but took nearly 350 years to do so.

While there is some uncertainty about the actual path of home prices, most of the evidence points to disappointingly low average rates of real appreciation of most homes.

Public attention seems to focus most on congested big cities that have little land available for building, and where land prices can get very high. But most cities have abundant land.

Precipitating Factors: The Internet, The Capitalist Explosion, And Other Events

It is worth remembering that there is no air-tight science of speculative market pricing. We have certainly made progress in understanding these markets, but the complexity of real life continues to prevail. Many of the factors that led to these booms had a self-fulfilling aspect to them, and they are thus difficult, if not impossible, to capture in predictive scientific explanations.

Amplification Mechanisms: Naturally Occurring Ponzi Processes

It is curious that people do not seem to believe the converse of the premise stated in our question: they do not believe that the market will surely go back down in a couple of years if it goes up dramatically. Their belief in the resilience of the market seems to stem from a generalized feeling of optimism and assurance, rather than a belief in the long-run stability of prices.

The subjective experience over the years of seeing stock market declines consistently reverse themselves has a psychological impact on our thinking that is hard to appreciate, or reconstruct, after the fact. Those who thought the market would go down and stay down became sensitized to their bad feelings from being repeatedly wrong, year after year. Those who consistently predicted a decline became painfully aware of a loss of reputation from being so wrong so often. Since our satisfaction with our views of the world is part of our self-esteem and personal identity, it is natural for the formerly pessimistic to want to settle on a different view, or at least to present themselves to the public with a different theme. Thus, the changed emotional environment will have an impact on their views – or certainly the expression of them – that is independent of any objective evidence supporting or refuting those views.

A related reason why an argument built around such a story has such appeal is that by presenting successful investing as a process of mastering one’s own internal impulses rather than taking account of our present situation in history, it invites the reader to forget what is special about the present time in terms of the level of the market. Normal people think a lot about controlling their own impulses – for example, about disciplining themselves to perform good work rather than wasting time, about staying slim rather than getting fat – and so arguments that appeal to such self-control have more resonance than articles about the history of price-earnings ratios.

Regret is an emotion that, psychologists have found, provides considerable motivation.

Envy of others who may have made more in the stock market than one earned at work in the past year is a related painful feeling, especially in that it diminishes one’s own ego.

When people first experience success in any area, there is of course a natural tendency for them to take new initiatives and develop their skills in hopes of achieving more such success.

Investors do not become truly confident in the [Ponzi] scheme until they see others achieving large returns.

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.

The News Media

Should the media be faulted for presenting debates on topics of little merit? One can argue that they ought to focus on a variety of topics of interest to general audiences so that the public can refine their views. yet in doing so, the media seem often to disseminate and reinforce ideas that are not supported by real evidence. If news directors followed only their highest intellectual interests in judging which views to present, the public might indeed find its consciousness constructively broadened. But that is apparently not how the media see their mission – nor do competitive pressures encourage them to rethink the matter.

Many news stories in fact seem to have been written under a deadline to produce something – anything – to go along with the numbers from the market.

Record overload – the impression that new and significant records are constantly being set – only adds to the confusion people have about the economy. It makes it hard for people to recognize when something truly and importantly new really is happening.

The media actively shape public attention and categories of thought, and they create the environment in which the speculative market events we see are played out.

New Era Economic Thinking

More often, it is the general public that is missing something by overreacting to the new era stories that become suddenly popular – missing the basic similarity between the latest stories and similar stories that appeared many times in the past.

There are times when an audience is highly receptive to optimistic statements and times when it is not.

Psychological Anchors For The Market

Nonconsequentialist reasoning: reasoning that is characterized by an inability to think through the elementary conclusions one would draw in the future if hypothetical events were to occur. People cannot decide until the events actually occur.

The effects of news stories on the stock market sometimes have more to do with discovery of how we feel about the news than with any logical reaction to the news. We can make decisions then that would have been impossible before the news was known. It is partly for this reason that the breaking off of a psychological anchor can be so unpredictable: people discover things about themselves, about their own emotions and inclinations, only after price changes occur.

Investor Learning – And Unlearning

Stocks have not always outperformed other investments over decades-long intervals, and there is certainly no reason to think they must in the future.