Sunday, February 13, 2011

Irrational Exuberance: Chapter 8

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.

This chapter is about herding and epidemics. Shiller explores the idea that humans (including investors) do not necessarily think independently, which leads to similar thinking and therefore similar investment decisions.

Shiller cites experiments by Deutsch and Gerard that illustrate that individuals will side with the opinions of a large group of people over even their own opinions! The experiments demonstrate that people believe the majority view to be accurate even when it conflicts with their own independent conclusions.

Even rationally-behaving people can fall victim to herding as a result of an "information cascade". Shiller describes an example where a customer encounters two empty, identical restaurants. He must choose randomly between the two, with no other information to go on. But the next customer that arrives has the benefit of seeing the choice of the first customer, which, absent other information differentiating the restaurants, may sway him to choose the same restaurant, on the basis that the first customer knew something he didn't. This cascade can continue as more customers arrive, resulting in one full and one empty restaurant, despite there being no discernible difference between the two.

People also accept long-standing sayings as fact, as a result of trusted word-of-mouth communication. Such myths usually start with the words "They say that...", and are believed by those who both hear and speak them. Shiller debunks a few of these common sayings: that only 10% of the human brain is used by most people, that the birth rate jumped after a power blackout, and that there were an unusually high number of suicides during the 1929 crash. People prefer to take a free ride on items like these; they will believe that some expert has confirmed it, and so they will go along with it. They are likely employing these same behaviours when they invest.

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