Saturday, February 12, 2011

Irrational Exuberance: Chapter 7

In the year 2000, while many market pundits expected the market to rise continuously upward, Robert Shiller warned about the stock market bubble, though not that many paid attention. While most were blinded by optimism, Shiller demonstrated using fundamental analysis that the market would generate poor returns for years to come. Learning from and understanding Shiller's rational approach to market valuation is likely to aid the investor in avoiding falling prey to the bubbles of the present and future.

Shiller now takes on the question of why the market is at the level it is at. This is an interesting question because it is not known to any degree of accuracy what the right market level should even be.

First, Shiller takes issue with popular accounts of investing psychology. These accounts would have you believe that investors are euphoric during booms, and panic-stricken during busts. But Shiller argues that this is not the case; instead, investors during these periods are trying to be sensible, but perhaps have certain modes of behaviour that guide their actions during periods of uncertainty.

But why would the Dow be priced at 14,000 as opposed to 4,000? What is causing the market to choose one level over another? Shiller believes two psychological anchors in particular play prominent roles: quantitative anchors and moral anchors.

Quantitative anchors have to do with what prices or price changes investors may believe to be appropriate, even if those beliefs are sub-conscious. Examples include yesterday's price, P/E levels of similar companies, and previous highs or lows. Quantitative anchors make the investor think an asset's price should be at a certain price.

Moral anchors, as defined by Shiller, have to do with the investor's opportunity cost for his money. Would the investor rather have X number of dollars tied up in the market, or has it reached such a level that he believes he should sell some shares to improve his standard of living? Moral anchors in the aggregate make this determination for the market.

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