Irrational Exuberance | Robert J. Shiller

Summary of: Irrational Exuberance
By: Robert J. Shiller


In ‘Irrational Exuberance’, economist Robert J. Shiller examines the factors driving widespread overvaluation in the late 1990s stock market and the post-2000 real estate market. He argues that investors tend to act irrationally, contrary to orthodox financial theory, which assumes rational decision-making. Shiller highlights historical examples of speculative irrationality and explores the impact of unreasonable expectations, cultural changes, media influence, and demographic shifts on financial markets. This book offers insight into the psychological basis of speculative bubbles and equips the reader with valuable knowledge to recognize potentially unsustainable market trends.

Irrational Investment

The economic system assumes that investors make rational decisions. However, substantial evidence suggests that their investment decisions are irrational. In the late 1990s, investors invested in the highly overvalued stock market based on their irrational beliefs. Even when the stock market was at an all-time high, people kept buying stocks despite being out of line with traditional relationships and fundamental values. After the 2000 crash, they transferred their almost superstitious belief in the unfailing market ascent from stocks to real estate instead of learning to be more conservative. The median price of homes equaled 7.7 years of per capita income by 2002 compared to 4.9 years in 1985, which even newspapers have started to call a “bubble.” This summary questions the core assumptions of modern-day economics and sheds light on the irrational nature of investors’ decisions.

The Real Estate and Stock Market Bubble of the 90s

Between 1994 and 2000, the Dow Jones Industrial Average tripled despite stagnant personal income and the Gross Domestic Product. The rise in stock prices was unjustified by earnings and corporate profits that grew at slower rates. The real estate market experienced an unprecedented increase, driven largely by speculation in the late 1990s through 2004. This boom was not fundamentally supported and had no correlation to population growth, interest rates, or construction costs. People were buying homes like they bought stocks in the ’90s, convinced that prices can only go up. However, house prices had historically compounded at 0.4% per year, and most of the land in the U.S. is still empty. The irrational belief that prices must go up is unfounded and unsupported by financial history.

Beware of High Price-Earnings Ratios

High price-earnings ratios lead to low returns and potential market crashes. The housing market is also susceptible to speculative booms.

Did you know that high price-earnings ratios usually result in low or negative returns? In January 2000, the price-earnings ratio hit an all-time high of 44.3, and precedents for such a high ratio were almost nonexistent. In 1929, a high ratio of 32.6 led to the famous market crash, and the S&P Index didn’t return to its pre-crash value until almost 30 years later. The third instance of a high ratio occurred in January 1966, leading to a 56% drop in real prices by 1975.

Unfortunately, there is no similar data available for the housing market since it was not previously considered a speculative investment. However, recent years have seen a significant rise in speculative investment in owner-occupied homes and their subsequent booms. It’s essential to be wary of high price-earnings ratios and the potential for market crashes in both the stock and housing markets. This book offers valuable insights into investing wisely and avoiding significant losses.

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