Irrational Markets — The Story of Robert Shiller and Behavioral Finance

Are stock markets rational? That is, do prices of shares, and other financial assets change primarily because of fundamental economic reasons? This is a critical question for investors who are always reading the news and analyzing research papers and financial results of companies and national economies.

Many institutional investors believe that the answer to this question is yes. Modern Portfolio Theory, first explained by Harry Markowitz, is based on the assumption that markets are essentially rational. Markowitz won the Nobel Prize for economics in 1990 for demonstrating how optimized portfolios can give investors the best mix of risk and returns.

Robert Shiller, Professor of Economics at Yale University and also a 2013 Nobel Prize winner in economics twenty-three years after Markowitz, initially agreed with the efficient market hypothesis. However, as Shiller began looking more closely at US stock market data since 1871, he found that prices “gyrate wildly up and down 4 to 20 times more” than they should if prices were based on efficient, rational markets. History also showed that periodic market booms and busts are much more common and not explained by rational markets.

Irrational Exuberance

From 1980 onwards, Shiller began publishing his findings that markets are irrational. This caused “a remarkable amount of controversy,” with most economics dismissing Shiller as not being a proper economist! All this began to gradually change. Shiller proved to be prophetic in anticipating three major stock market crashes:

• Shiller’s study of the 1987 stock market crash showed that traders made decisions based more on emotions than rational analysis.
• In 2000 Shiller published a book, “Irrational Exuberance,” that warned that the dot com driven stock market was a bubble. Shiller was proven to be correct when the market fell 44% from its highs in September 2000 to March 2003, destroying millions of dollars in investors’ savings.
• From 2005 onwards, Shiller began warning that the US housing market was unstable and that stock market price rises were unsustainable. Shiller wrote that “there is a significant risk of a very bad period,” and in September 2007, he predicted a significant market bust. Shiller was again correct, and the US stock market (S&P) fell by 51%, causing one of the worst global recessions

Behavioral Finance

Shiller does not dismiss the need for information and analysis but says that markets are often influenced by irrational behavior. There are two main reasons for this irrational behavior, and these form the foundations for a new theory called “Behavioral Finance.”

Firstly, says Shiller, investors look as much to what other investors are doing as to the fundamentals of companies and economies. Shiller likes quoting the great economist, John Maynard Keynes, who compared the stock market to a beauty contest where “It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest. We devote our intelligence to anticipating what average opinion expects the average opinion to be.” Thus, according to Shiller, investors buy because others are buying and sell when others are selling, irrespective of the fundamentals of the share prices.

An extremely important warning by Shiller is that “When speculative prices go up, creating successes for some investors, this may attract public attention, promote word-of-mouth enthusiasm, and heighten expectations for further price increases. This process in turn increases investor demand and thus generates another round of price increases. If the feedback is not interrupted, it may produce after many rounds a speculative ‘bubble,’ in which high expectations for further price increases support very high current prices. The high prices are ultimately not sustainable since they are high only because of expectations of further price increases, and so the bubble eventually bursts, and prices come falling down. The feedback that propelled the bubble carries the seeds of its own destruction, and so the end of the bubble may be unrelated to news stories about fundamentals.”

Secondly, Shiller and other behavioral finance economists say that human beings have in-bult biases. These are so ingrained that our behavior is predictably irrational! Two significant biases that Shiller talks about are:

• Biased self-attribution. This, according to Shiller, is “a pattern of human behavior whereby individuals attribute events that confirm the validity of their actions to their own high ability and attribute events that disconfirm their actions to bad luck or sabotage.” In this way, people do not learn from or accept their mistakes.
• Herd Mentality bias. This is the tendency of investors to be influenced and to do what other investors are doing. Thus, investors rely on emotion rather than independent rational analysis.

Individual and group biases have now grown into a major area of study, and the above are only two of the most critical biases that Shiller has identified.

Shiller does not entirely dismiss rational decision making but says that “behavioral finance has led to a profound deepening of our knowledge of financial markets. This research is not a method to make a lot of money off of financial market inefficiency very fast and reliably,” but it gives us an important perspective that we must always keep in mind when investing.

Robert Shiller

All four of Shiller’s grandparents were immigrants to the US. This is yet another example of how immigrants have successfully built the US. Shiller’s father was an engineer and entrepreneur. Shiller was born in 1946 and said that “Something that I got from my father is an appreciation for invention.” Also, following his engineer father, Shiller places great emphasis on “theorizing after collecting data.”

Shiller was always interested in economics and studied at MIT and the London School of Economics. What made Shiller look for a different theory for investing and finance was his independent nature. As a child, Schiller was always curious to find out what was really true. He says that “I have the same skeptical nature [as my father]. When I was a child, my Sunday school teacher complained to my parents that I had a bad attitude. I didn’t believe anything that this guy said. It’s still with me that I’m just naturally skeptical of people who look impressive — but I’m naturally wondering if it’s real.”

© Kaikhushru Taraporevala