PDF Summary:Irrational Exuberance, by Robert J. Shiller

According to Nobel laureate economist Robert J. Shiller, mainstream economists’ faith in efficient markets is wildly misguided. Shiller argues that financial markets are rife with speculation, meaning that investors often drive prices far beyond their fair value. In Irrational Exuberance, Shiller contends that speculative bubbles pervade financial markets and outlines his theory of the structural, cultural, and psychological considerations that create and sustain these bubbles.

In this guide, we’ll first examine Shiller’s arguments that speculative bubbles have formed in three key US financial markets: the stock market, the housing market, and the bond market. Next, we’ll discuss Shiller’s theory that irrational exuberance—unwarranted optimism driven by structural, cultural, and psychological factors—is the driving force behind these bubbles. To conclude, we’ll examine Shiller’s recommendations to financial leaders and the general public for mitigating these bubbles.

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But Shiller argues that this line of reasoning is unfounded. First, he notes that in the ten years following two previous peaks in CAPE ratios—September 1929 and January 1966—short-term bond rates actually outperformed returns from the stock market. In a similar vein, he points out that in the thirty-year periods leading up to 2010 and 2011, prominent corporate bond indices outperformed the S&P 500. He concludes that the evidence simply doesn’t support the thesis that stocks have consistently outperformed bonds—leaving us no reason to believe that the present high CAPE ratios are justified.

(Shortform note: Although Shiller may be correct that stocks haven’t consistently outperformed bonds historically, they have in recent history: Between 2013 and 2023, the S&P 500’s corporate bond index hovered around 2% annual returns, whereas the S&P 500 itself delivered nearly 10% annual returns in this same timeframe.)

Irrational Exuberance as the Foundation of Speculative Bubbles

Having laid out his case that speculative bubbles do exist, Shiller then turns toward the origins of these bubbles. In this section, we’ll discuss Shiller’s theory of speculative bubbles and examine the structural components that enable them to arise, the cultural components that enable them to grow, and the psychological components that restrict them from growing indefinitely.

The Foundation of Speculative Bubbles

According to Shiller, speculative bubbles are made possible by feedback loops. He argues that feedback loops in investing markets reinforce the price changes caused by new financial information, leading to disproportionate price increases. To illustrate, he examines the dotcom boom of 2000.

How Feedback Loops Create Speculative Bubbles

Shiller writes that when relevant information drives a security’s price higher, that price increase itself often spurs further price increases, creating a feedback loop. These loops, he explains, can occur for various reasons. For example, if investors learn that Netflix’s stock has risen consistently over the past year, they might expect further increases going forward, leading them to purchase more Netflix stock and drive the price even higher.

(Shortform note: Feedback loops can also be driven by a herd mentality—a phenomenon in which investors all mindlessly buy or sell the same security, assuming that others have done the relevant research. For example, if the price of Amazon were rising sharply, many investors might assume that those purchasing Amazon have done so for good reason, causing them to unreflectively buy Amazon themselves and drive its price up further.)

As evidence that such feedback loops can occur, Shiller points to Ponzi schemes. He notes that these schemes initially rely upon a plausible (but specious) investment opportunity. For instance, ex-lawyer Scott Rothstein offered investors the opportunity to purchase shares of legal settlements, promising them a profitable return when he won the settlement. Then, the scheme’s perpetrator convinces a second round of people to invest, using these new funds to pay the first round of investors. Then, once people hear about the success of the initial investors, that leads to a third round of investors whose funds are used to pay the second round. And so on.

(Shortform note: Despite being the most well-known type of financial scam, Ponzi schemes continue to abound in the US, with researchers estimating that investors collectively lost over $5 billion to Ponzi schemes in 2022. These researchers note that a quarter of these Ponzi schemes involved cryptocurrency. Some analysts even believe that Sam Bankman-Fried’s alleged fraud while at FTX—in which he supposedly used billions of dollars from FTX users to fund speculative investments at his private trading firm—was essentially a Ponzi scheme.)

Shiller writes that if you replace the specious investment opportunity with genuine financial news about a security, you can understand how feedback loops afflict investment markets. When investors hear auspicious news about a stock, they bid up its price. Then, when a second round of investors hear about the price increase, they also decide to invest, causing a further price increase. Through iterations of this process, securities’ prices can rise significantly higher than would be rationally justified by the initial news.

(Shortform note: Experts point out that in the world of professional trading, investors aren’t merely reacting to news about a security, but rather the event itself—even before it’s being reported by mainstream news outlets. In other words, professional investors aim to predict what will be reported by news outlets so that they can trade on this information before it reaches amateur investors’ ears.)

Case Study: The Factors Behind the Dotcom Boom

To determine which kinds of specific information can spark these feedback loops, Shiller examines the perceptions that set the stage for the dotcom boom. And although Shiller lists 12 such factors, we’ll focus on three key ones: the internet, the Baby Boom, and the creation of 401(k)s.

Factor #1: The Internet

Shiller points out that in the 1990s, investors expected the burgeoning internet to drive unprecedented economic growth. He notes that this narrative took root because impressive corporate earnings growth in 1994 through 1996 seemingly occurred in lockstep with the growth of the internet—though the internet actually had little to do with it, as internet companies were not yet turning large profits. But, because investors’ perceptions drive stock prices, rather than the reality itself, the internet’s perceived economic import spurred investors to purchase technology stocks.

(Shortform note: Researchers point out that one reason why early internet stocks soared to such high valuations is because of a perceived first mover advantage—the notion that being one of the first companies to use a new technology provides a crucial advantage over competitors. However, they argue that the supposed first mover advantage of early internet companies was overstated: In fact, these early companies suffered a strategic burden because they didn’t yet understand how best to monetize the internet.)

Factor #2: The Baby Boom

Shiller argues that inflated economic expectations because of the Baby Boom (the US population surge following World War II) created heightened confidence that left the market ripe for speculation. He relates that several pervasive theories linked the Baby Boom with economic prosperity in the 1990s. For example, one theory held that Baby Boomers—who began preparing for retirement in the ’90s—would purchase stocks to fund their retirement accounts, leading to widespread stock market growth. Another theory held that Baby Boomers would invest aggressively because they hadn’t experienced the economic turmoil of the Great Depression, and that this investment would lead to price hikes.

(Shortform note: According to analysts, one corollary of the theory that Baby Boomers’ retirement investments would increase stock prices in the ’90s is that, as Baby Boomers liquidate their accounts in the 2020s to fund their retirement, the stock market should drop because of this widespread selling. However, others argue that because markets are efficient, this potential for widespread selling is already priced into the stock market, meaning a stock market crash is unlikely even if Baby Boomers do liquidate their retirement funds.)

Factor #3: The Beginning of 401(k)s

Finally, Shiller points out that in 1982, the first 401(k) plan was created, giving employees the chance to allocate some of their income to a retirement fund split between stocks and bonds. As 401(k)s became more popular, they increased employees’ exposure to the stock market, creating a new generation of would-be investors. Consequently, demand for stocks increased, providing further fuel for price increases.

(Shortform note: Since the onset of 401(k) plans in 1982, a wide array of retirement plans have become available to investors, each with its own pros and cons. For instance, a traditional individual retirement account (IRA) allows investors to make tax-deductible contributions to their retirement funds, though withdrawals in retirement are subject to income tax. By contrast, a Roth IRA doesn’t allow for tax-deductible contributions to a retirement fund, but withdrawals in retirement are tax-free.)

The Growth of Speculative Bubbles

Although feedback loops often set the stage for speculative bubbles, Shiller contends that two cultural features sustain and strengthen these bubbles once they take root: media coverage of rising stock prices and economic theories that justify these prices.

How Media Coverage Furthers Speculative Bubbles

According to Shiller, when it comes to investing, the media doesn’t just passively present the news. He contends that the media actively contribute to investing highs and lows by drawing attention to price changes, which causes further price changes. To show as much, Shiller examines media coverage leading up to two key crashes in the US stock market: the 1929 crash and the 1987 crash.

Crash #1: Black Monday and Black Tuesday, October 1929

Black Monday and Black Tuesday refer to Monday October 28 and Tuesday October 29, 1929. During this two-day span, the Dow Jones dropped a total of 23% due to single-day drops of 12.8% and 11.7%—the two largest single-day drops in US history at the time. Normally, we would expect such drops to stem from concrete information impacting companies’ business fundamentals (the information that reflects a company’s financial health, such as its revenue and cash flow). But Shiller points out that media outlets reported no such information: The news was replete with mundane stories that had little to do with corporations’ fundamentals.

(Shortform note: The calamitous losses on Black Monday and Black Tuesday had wide-reaching implications beyond the stock market—because they depleted investors’ wealth overnight, the US economy tanked instantly. Consequently, these two days ushered in the period known as the Great Depression (1928-1939), in which crippling unemployment and widespread deflation were pervasive in the US.)

However, Shiller says, news outlets did report another story that could have influenced the stock market—namely, the temporary market drop of Black Thursday (October 24, 1929), in which the Dow was down 12% at one point but recovered by the day’s end. Shiller notes that on Sunday evening and the morning of Black Monday, prominent news outlets ran stories highlighting the tenuous nature of the market in the wake of Black Thursday. According to Shiller, this suggests that Black Monday and Tuesday didn’t result from news about companies’ financial prospects, but rather from increased awareness of market volatility. By making the stock market’s volatility salient, the media caused a chain reaction of price decreases on Black Monday and Tuesday.

(Shortform note: Although Shiller’s explanation of Black Monday and Tuesday may be correct, it differs from the mainstream economic explanations, which instead cite a proliferation of factors that contributed to the crash. For example, experts note that many investors were purchasing stocks on credit in 1929, meaning that margin calls when the stock market dropped forced them to sell their stocks, causing further losses. Further, the Federal Reserve sharply raised the federal interest rate from 5% to 6% in the weeks before the crash, which may have caused financial markets to be less stable and thus prone to a crash.)

Crash #2: Black Monday, October 1987

In a similar vein, Shiller discusses the next Black Monday, on October 19, 1987, in which the Dow Jones dropped nearly 23% in a single day—doubling the single-day drops of 1929. As an economist at Yale at the time, Shiller took advantage of this crash by surveying professional and amateur investors the week after the crash to collect their thoughts on the day of the crash. His surveys asked investors to rate the importance of different news stories from October 19 in their assessment of the stock market crash. As Shiller relates, these investors overwhelmingly responded that stories about the Dow’s morning decline—when it dropped around 7%—were the most important for their market evaluation.

(Shortform note: Experts point out that Black Monday in 1987 illustrated the interconnected nature of international financial markets, as the Dow’s crash on October 19 was followed by similar crashes in markets across the world. For example, London’s Financial Times 100 index was down 25% by October 23, and Japan’s stock market was down 13%. Thus, while the US’s stock market lost $500 billion in value on October 19, the total worldwide loss was estimated at over $7 trillion.)

Shiller reasons that although the Dow’s initial fall in the morning may have had something to do with business fundamentals, its subsequent decrease that day was largely driven by news of the initial decrease. He notes that this conclusion was shared by the Reagan administration’s Brady Commission—a group assigned with uncovering the causes of the crash—who found that while initial news reports about unfavorable tax legislation for corporations spurred the initial price drop, further news reports about the price drop itself encouraged further selling, leading to a calamitous crash.

(Shortform note: The Brady Commission’s report also clarified that much of the widespread selling that drove stock prices down on Black Monday was the result of computerized trading: automated programs used by institutional investors that automatically sold stocks under certain conditions. Because these programs were designed to sell stocks that dropped by a certain percentage, they caused initial price drops to give rise to further declines.)

How New-Era Economic Theories Further Speculative Bubbles

In addition to pervasive media coverage, Shiller points to a cultural tendency to justify market growth in terms of “new era” economic theories—theories that claim we’ve entered into a new economic era, meaning such growth will continue indefinitely. According to Shiller, new-era thinking further inflates speculative bubbles by causing investors to believe market growth is inevitable. And while Shiller examines new-era thinking during several eras of market booms, we’ll focus on two in particular: the 1920s and the 1950s.

(Shortform note: Although Shiller explicitly states that he’s quoting other economists, analysts, and authors who’ve used the term “new era” to describe the state of the economy, he’s responsible for popularizing the term and bringing it into standard economic jargon.)

Era #1: New-Era Thinking in the 1920s

During the bull market of the 1920s, several factors conspired to create a widespread belief that the US had entered a new economic era. As Shiller relates, the ’20s witnessed a technological explosion that was evident not just to the wealthy, but to the working class as well—automobiles became commonplace by the decade’s end, and electricity became standard even in rural areas that had previously relied on kerosene lamps. Further, the sharp increase in radio availability created a population that felt more interconnected than ever before.

(Shortform note: According to experts, the proliferation of technology in the home—including electricity and related items like refrigerators, washers, and heaters—meant that it required much less time to run a household. Consequently, women whose time had previously been devoted exclusively to managing the house now had time to enter the workforce, leading to economic growth that further strengthened the idea of a new economic era.)

According to Shiller, these developments ushered in a belief that the US had entered a new industrial age that promised massive economic growth. For example, the head of advisory firm Moody’s Investing Service, John Moody, explicitly stated in 1928 that the US was headed into a new era of civilization capable of perfecting itself. Similarly, renowned Yale economist Irving Fisher concluded in 1929 (just before the crash) that the stock market’s high valuation would persist indefinitely. Theories like these, Shiller explains, fostered a sense of unqualified optimism among investors that consequently led them to bid up stock prices even higher.

(Shortform note: Although many bought into the new-era thinking of the 1920s, a few prescient investors avoided the hype. Most famous among these is Roger Babson, a statistician and investor who in a 1929 speech warned of a looming crash. According to Babson, the pervasive speculation in the stock market suggested that a massive correction was overdue, and he therefore recommended that investors trading on margin immediately pay it off and withdraw their funds from the market.)

Era #2: New-Era Thinking in the 1950s

Similarly, Shiller contends that the mid-1950s, which saw a 94% inflation-adjusted stock market rise between 1953 and 1955, was rife with new-era thinking that stemmed from several factors. First, as Shiller notes, the apparent peace in the wake of World War II gave rise to extreme optimism. Moreover, he points out that the sudden introduction of television instilled a vision of imminent technological innovation into Americans’ minds. Finally, because inflation had remained extremely low in the mid-’50s, many Americans believed the dollar would remain the strongest currency in the world.

(Shortform note: According to experts, the economic boom of the 1950s—which saw GDP skyrocket from $200 billion to $500 billion—was largely driven by increased government spending. The government, they point out, began spending lavishly on infrastructure, education, and military technologies throughout the 1950s. This increased spending stimulated the economy, leading to low unemployment and relatively high wages throughout the decade.)

Shiller argues that these factors led to excessive financial optimism in the ’50s and even into the ’60s. For example, in 1955, US News and World Report ran a story explicitly claiming a new era was imminent because war had ceased, recessions had been short-lived, and employment was high. Such theories, he notes, led investors to forego caution and invest aggressively. Ultimately, this resulted in a relative plateau of stock market growth between 1966 and 1992, suggesting the market had become overpriced by the mid-1960s.

(Shortform note: The new-era thinking of the 1950s and ’60s was less potent than the unqualified optimism of the 1920s for one reason: The Cold War. Many Americans’ enthusiasm was tempered by continued US involvement in the Cold War with the Soviet Union, because the threat of communism—or, worse yet, nuclear apocalypse—loomed large in the public psyche.)

The Limits of Speculative Bubbles

While media coverage and new-era thinking can strengthen speculative bubbles, Shiller maintains that psychological factors determine the extent to which these bubbles will grow. In particular, he argues that two types of psychological anchors—quantitative and moral—prevent speculative bubbles from growing indefinitely.

Quantitative Anchors

Shiller explains that quantitative anchors cause investors to keep stock prices relatively stable on a day-to-day basis. To illustrate the concept of quantitative anchors, he points to an experiment by Daniel Kahneman and Amos Tversky, in which they asked participants a question with an answer between 1 and 100 while displaying a wheel of fortune that landed on a random number between 1 and 100. Participants’ answers, they found, were heavily influenced by the wheel’s number—for instance, if participants were asked “What percentage of Americans earn above $50k annually?”, their answers were significantly higher if the wheel landed on 85 than if it landed on 35. The number before them thus anchored their response.

(Shortform note: Since Kahneman and Tversky’s original experiment, the impact of quantitative anchors has been repeatedly and robustly confirmed by researchers. For instance, in a later experiment, researchers asked participants to list the last two digits of their social security number before asking them how much they would pay for a given object (like a bottle of scotch or a box of chocolates). They found that individuals with higher social security numbers consistently gave larger values when asked what they’d be willing to pay, thus showing that their social security number anchored their response.)

According to Shiller, this phenomenon keeps stock prices mostly consistent on a day-to-day basis. For example, if Tesla stock is trading at $245, investors will likely be anchored by this number and therefore avoid driving the price up to (say) $300 in a single day. In practice, this means that quantitative anchors restrict speculative bubbles from rising (or falling) excessively in a short time span.

(Shortform note: Although quantitative anchors can be a powerful tool for keeping stock prices stable, they’re often outweighed by news concerning business fundamentals. For example, on February 3, 2022, Meta’s stock dropped 26% from about $325 to about $240 after a disappointing earnings report, costing Meta $232 billion of its market capitalization.)

Moral Anchors

In a similar vein, Shiller contends that moral anchors determine how far a speculative bubble can grow before bursting. Moral anchors, he explains, refer to the narratives and reasons that convince investors to keep their money invested in the stock market rather than selling their stocks and cashing out. When a moral anchor is weak, investors will be more likely to sell their stocks and earn a tangible profit, causing a bubble to burst when this selling is widespread. By contrast, when a moral anchor is strong, investors will be more likely to hold their stocks and thus perpetuate speculative bubbles.

(Shortform note: While moral anchors explain why investors continue to hold their stocks when they’ve made money in the stock market, a different factor explains why investors continue to hold their stocks when they’ve lost money—namely, the belief that losses aren’t real until you cash out. For example, if you invested $5,000 in Netflix and its stock immediately dropped 20%, you might refuse to sell your holdings because the $1,000 loss only feels genuine after you’ve cashed out.)

Shiller compares the narratives that drive investment decisions to those that influence juries. He says psychological experiments show that rather than assessing the quantitative evidence that the defendant committed a crime, juries instead consider the plausibility and coherence of the defendant’s story versus the prosecution’s. Analogously, Shiller suggests that these reasons—rather than quantitative analysis of dividend yields or CAPE ratios—heavily influence investors’ behavior. For instance, if you initially purchased tech stocks in the late ’90s and earned massive returns, you might choose to continue holding these stocks rather than selling if the dominant narrative says that tech stocks will only increase in value.

(Shortform note: For investors seeking to improve their quantitative analysis skills rather than simply relying on the dominant narratives in financial circles, Robert G. Hagstrom’s The Warren Buffett Way offers a helpful starting point. In The Warren Buffett Way, Hagstrom outlines the key quantitative metrics that Warren Buffett uses to evaluate companies’ prospects as an investor. For instance, he outlines what return on equity is and how it measures companies’ efficiency in generating prospects, in addition to explaining why owner earnings is a superior metric to cash flow.)

How to Mitigate Speculative Bubbles

Having not only shown that speculative bubbles exist, but also how structural, cultural, and psychological elements give rise to and sustain these bubbles, Shiller proceeds to discuss what we can do to mitigate speculative bubbles. In this section, we’ll briefly examine Shiller’s advice for financial leaders and the general public to curb speculation in financial markets.

Shiller’s Advice for Financial Leaders and the Public

Although there’s no foolproof way to prevent speculative bubbles from taking root, Shiller maintains that financial leaders and the public can take steps to limit speculation. He argues that financial leaders should speak openly when they think the market is overpriced, and the public should diversify their portfolios to prevent prices in certain markets from rising irrationally.

Schiller writes that, when key financial figures voice candid views about financial markets, it can help the market remain steady and avoid speculative bubbles in either direction. For example, when influential financial leaders voice suspicions that the market is overpriced, that can curb investors’ enthusiasm and pre-empt further speculative trading. By contrast, when a potential crash is looming, financial leaders who voice confidence in the market can help it remain afloat. In either case, Shiller points out that because non-professional investors listen closely to financial leaders, these leaders can help mitigate speculation.

(Shortform note: Beyond financial leaders, it’s also tempting to think that financial institutions, like the US Federal Reserve, should enact policies that address speculative bubbles. However, according to financial experts, these policies would likely do more harm than good. They argue that, rather than attempting to address speculative bubbles themselves, financial institutions should focus on the effects of these bubbles in the form of inflation and employment rates, so that when the bubble does burst its effects are less harmful.)

According to Shiller, the general public also holds some responsibility for preventing speculation. He argues that the public shouldn’t invest exclusively in the stock and real estate markets, but should instead diversify their portfolios across various asset types. After all, rampant trading in the stock and real estate markets, driven by the belief that these markets can only increase, leads directly to the speculative bubbles that Shiller warns of. So, by limiting their exposure in these markets, investors can help prevent speculation from taking root—and protect themselves from big losses when bubbles eventually burst.

Further Advice for Amateur Investors to Avoid Speculation

In addition to Shiller’s recommendation of diversifying your portfolio, experts offer several other strategies for amateur investors to avoid getting swept up in speculative bubbles. These strategies include:

• Don’t invest in securities simply because everyone else is doing so, since these securities are most prone to speculation.

• Establish a tentative target price at which you’ll sell an asset so you’re less likely to hold an asset whose price is driven by speculation.

• Rebalance your assets frequently to ensure that your portfolio stays diversified, even when one asset class rises or drops.

• Recognize that your own investing goals likely differ from those of other investors, so you don’t have to invest in the trendy assets preferred by others.

Although none of these strategies is a foolproof way to avoid owning a speculative asset, they collectively mitigate the risk of doing so.