Irrational Exuberance

By: Robert Shiller

In this engaging book, named after the term coined by Alan Greenspan, Shiller looks at various asset markets across history through a psychological perspective. Is there a discernible pattern to bubbles, ex ante? What are the factors precipitating “unsustainable” price increases in a certain security or asset class? How does market participants’ psychology–an element any student of Finance or investments knows is relevant to price progression–rationalize price movements? Is it even possible to know if a valuation is “excessive” at any given time, considering the increasingly significant role of “growth” to valuations?

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These are some broad questions that Shiller aims to address. He begins with a thorough historical evaluation of equity, fixed income, and real estate markets, highlighting eras of increased speculation followed by sharp declines—for instance the 1901, 1929, 1966, 2000, and 2008 peaks in equity markets. He arrives at a primary conclusion that “fundamental drivers” cannot explain the volatility of asset markets, nor can they explain why seemingly disparate markets—real estate markets in London, Los Angeles, New York, and Frankfurt, for example— co-move.

This is followed by a structural, cyclical, and psychological discussion in regards to what could be happening behind the scenes during bubbles. Shiller is able to add some science to the art of “getting a feel” for the market, identifying naturally occurring “Ponzi schemes” in the form of self-reinforced price-to-price feedback, for instance, through which investors, as a herd, go long (short) assets or securities that they have witnessed others long (short) profitably. He develops a theory of stories and feedback loops, including anecdotes, arguing that bubbles might even be identifiable by a disproportionate increase in the number of people simply talking about fortunes made in the markets—think about the number of real estate flipping success stories floating around pre-2008!

Shiller introduces the powerful Cyclically Adjusted Price-to- Earnings (CAPE) ratio, which strives to elicit a smoothed valuation of a company while accounting for macroeconomic forces, namely inflation. The CAPE ratio has peaked at every market peak—prior to “bursting”—in at least the last century. Sharp shifts in the CAPE, then, could inform the medium to long –term investor on shifting market consensus that might soon be corrected.

Higher Level View of Market Psychology

This is an invaluable read that provides a perspective on markets grounded in psychology, real-world events, and sound economic logic. Shiller provides a robust mechanism to refute the divine efficient markets hypothesis while arming readers with precise frameworks to assess speculation and whether it is “excessive.” He concludes with some interesting ideas that could, if implemented as described, reveal the volatility accounted for by speculative behavior that is “detached from reality.”

Financial markets are zero sum games played by human agents or algorithms designed by human agents. The algorithms either use logic implicit in human traders’ actions, or, in the case of machine learning and AI, attempt to process swathes of data in a statistical model hoping to replicate the human brain. As such, any superior understanding of market participants’ psychology can prove valuable to investors. While the book excludes any specific investment advice, the “higher level thinking” promoted by Shiller equips the average investor with a lens to scrutinize how buyers and sellers are reacting to information—or lack thereof.

This higher level thought brings the average investor ever closer to playing the players, not just the game.

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We rate this book a 4.8/5.0.

About Robert Shiller

Robert James “Bob” Shiller is an American Nobel Laureate, economist, academic, and best-selling author. He currently serves as a Sterling Professor of Economics at Yale University and is a fellow at the Yale School of Management’s International Center for Finance. Shiller has been a research associate of the National Bureau of Economic Research (NBER) since 1980, was vice president of the American Economic Association in 2005, and president of the Eastern Economic Association for 2006–2007. He is also the co‑founder and chief economist of the investment management firm MacroMarkets LLC. He is widely known for devising the Case-Shiller index with Karl Case and Allan Weiss, a widely used real estate valuation metric and the already mentioned CAPE ratio. Shiller rose to fame by arguing in 1981 that no rational expectation of the future could explain valuations, which came to light in October 1987—dethroning the efficient markets hypothesis. He has been the recipient of numerous accolades, including the Deutsche Bank Prize in Financial Economics in 2009, and is famed for calling market tops prior to declines, specifically in the years 2000, 2005, and 2007.

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