Bubbles, Human Judgment, and Expert Opinion

Financial Analysts Journal ISSN: 0015-198X (Print) 1938-3312 (Online) Journal homepage: https://www.tandfonline.com/loi/ufaj20 Bubbles, Human Judgment, and Expert Opinion Robert J. Shiller To cite this article: Robert J. Shiller (2002) Bubbles, Human Judgment, and Expert Opinion, Financial Analysts Journal, 58:3, 18-26, DOI: 10.2469/faj.v58.n3.2535 To link to this article: https://doi.org/10.2469/faj.v58.n3.2535 Published online: 02 Jan 2019. Submit your article to this journal Article views: 110 View related articles Citing articles: 13 View citing articles Full Terms & Conditions of access and use can be found at https://www.tandfonline.com/action/journalInformation?journalCode=ufaj20 PERSPECTIVES Bubbles, Human Judgment, and Expert Opinion Robert J. Shiller he widespread public disagreement about endowments. Before the market peak in March whether the U.S. stock market has been 2000, those who manage university endowments undergoing a speculative bubble since had not withdrawn en masse from the stock market. T about 1995 reflects underlying disagree- According to a National Association of College and ment about how to view human judgment and University Business Officers (NACUBO) Endow- intellect. Many argue that the market, or major com- ment Study, in 1999, the median endowment had ponents of it, has been undergoing a bubble and 54.7 percent in U.S. equity and another 10.5 percent that, with the P/Es of major companies still very in non-U.S. equity. And most endowment portfo- high, the bubble has not burst completely. This lios remained in U.S. stocks, so they continued to group includes some writers for the Economist, the be involved in, not withdrawing from, the market Wall Street Journal, and Barron’s. Apparently, it is just before its peak. essential to their notion of a bubble for investors’ Those who manage university endowments actions to have been, in one way or another, foolish. have at their disposal some of the finest scholars and Others sharply disagree with the bubble stories, university trustees drawn from the highest ranks of and it is precisely this intimation of foolishness that the business world. Who would presume to call seems to bother them. Of course, some investors are these people foolish? But if one wishes to attribute foolish, they will admit, but they find the idea that the market’s behavior to human error, calling the investors by and large have been foolish to be sim- experts foolish is apparently what one must do. ply implausible. Rather, they will say, the high val- I believe that the stock market has indeed been uations the market has placed on the stock market caught in a speculative bubble in recent years recently can be attributed to the actions of rational (Shiller 2000). But the kind of less-than-perfectly- investors who are wrestling with hard-to-interpret rational behavior that underlies the bubble is not evidence about such issues as how much recent abject foolishness. It is not the error of fools. It is technological innovation will promote future earn- more the error that afflicts some of Shakespeare’s ings growth. Suggesting that investors in general tragic figures—in the sense of having subtle weak- have been irrational seems arrogant and presump- nesses or a partial blindness to reality. The kinds of tuous. errors that people have been making and that The dispute about whether we have been in a underlie the recent stock market bubble do reflect bubble is not simply about whether P/Es have human shortcomings—but exactly the kinds of become too high. One can argue that P/E multiples shortcomings that can infect the thinking of profes- have been or are too high without saying that some- sors, analysts, and trustees as much as anyone thing irrational underlies the high values. One can else’s. The current situation in financial markets is argue that the market has merely not taken certain simply a fertile ground for the amplification of the facts into account and will do so once these facts kind of errors even experts can make. have been properly disseminated. The idea that My aim is to draw attention to human foibles there has been a speculative bubble goes beyond that we all are subject to and that research in psy- high or low P/Es; the concept of “bubble” implies chology, behavioral finance, and other social sci- some less-than-rational aspect of investor behavior. ences reveals thoroughly and systematically. What Has investor behavior been irrational? One of I am doing is rather like what psychologists do the most important arguments that foolishness has when they show, using certain optical illusion not brought us the high valuations in the aggregate charts, that we all tend to make certain characteris- market comes from observing the decisions made tic visual-recognition errors and like what sociolo- by experts—for example, managers of university gists do when they point out how contagion of idea patterns underlies the spread of political ideologies. Robert J. Shiller is professor of economics at Yale Uni- In this article, I will expand on the sort of versity and principal at Case Shiller Weiss, Inc. This irrationality that seems to be at work in the mech- article derives in part from Irrational Exuberance anism by which bubbles are amplified. I will pur- (2000), winner of the 2001 Commonfund Prize. sue the nature of less-than-perfect rationality not 18 ©2002, AIMR® Bubbles, Human Judgment, and Expert Opinion only among the general class of investors but also investor feedback have been defined. For example, among experts—that is, the errors characteristic of Barberis and Shleifer (2000) developed a model of investment professionals. speculative bubbles that relates demand for a par- ticular investing style to an average of past returns, Feedback and Bubbles but in their model, excess returns are defined as excess returns of investments in one style over The essence of a speculative bubble is the familiar another. They used their model to show that not feedback pattern—from price increases to increased only does the feedback amplify price movements, investor enthusiasm to increased demand and, it also causes assets in one style to move together hence, to further price increases. The high demand too much. They also showed that assets in different for the asset is generated by the public’s memory of styles may tend to move together too little. Their high past returns and the optimism the high returns model can explain such events as the Nasdaq bub- generate for the future. The feedback can amplify ble and burst of 1995–2001 at a time when the positive forces affecting the market, sending the nontechnology stocks showed relatively mild market to higher levels than it would go if it were bubblelike behavior (see also De Long, Shleifer, responding only directly to these positive forces. Summers, and Waldman 1990 and Hong and Stein Note that a bubble is not indefinitely sustainable: 1999). Prices cannot go up forever. And when price In this article, I want to step back from the increases end, the increased demand that the price formal models of speculative bubbles and ask (1) increases generated also ends. Then, a downward whether this kind of feedback of price change to feedback pattern can replace the upward pattern. further price change is plausible at all and (2) In one model of a speculative bubble (Shiller whether it is consistent with what we know about 1990), the demand for shares depends on a “distrib- investment experts who, apparently, commonly go uted lag” of past returns—that is, on a weighted along with bubbles or, at least, do not act to offset moving average of past returns, with weights that bubbles. decline through time into the past—and depends It is important to realize that the bubble theory on some other precipitating factors, such as earn- requires only that past price changes produce an ings growth, that affect perceptions of stocks inde- inconstancy in our judgments, not that we foolishly pendently of returns. In this model, demand is most believe that past increases must continue. The strongly boosted by past returns if the high returns theory does not require that we forecast future came in the past few months, less strongly boosted price changes by some mechanical extrapolation if the high returns came not in the past few months rule or that we place rulers to chart paper to fore- but within the past few years, and only a little cast. It requires only that our observations of the boosted if the high returns came not in the past few past price changes alter the way we resolve the years but in the past few decades. The reasons that confusing array of conflicting information that we the weights in the weighted average of past returns must all sift through in judging the market. decline into the past are that we remember the more Ultimately, people who make asset allocations distant past less clearly, we hear stories about the must use their subjective judgment about the prob- more distant past less often, and we tend to be ability that stock trends will continue. This neces- aware of institutional or cultural changes that make sity is true for experts as well as the general public. the more distant past seem less relevant than the Although experts have the help of formal statistical near past. models, we all understand that these models are If supply is relatively fixed, this demand model only as good as their specific assumptions. Assess- implies that price is itself a distributed lag on the ments of trends and probabilities that underlie other factors that affect demand.

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