Speculation, Storytelling, and the Perils of Overconfidence
Emotional attitudes frequently overwhelm objective assessments, leading to risks disguised as opportunities in financial markets.
Not every financial crash comes before an easily recognizable mania. There’s not a Dutch Tulip Mania that signals an obviously bad investment to the public. Instead, there’s a more subtle set of attitudes that pumps stock prices beyond what they should be.
Economist Robert Shiller describes this phenomenon in his book, Irrational Exuberance:
“Irrational exuberance is the psychological basis of a speculative bubble. I define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, and, in the process, amplifies stories that might justify the price increase and brings in a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.”
Shiller draws a sharp line between gambling and investing. Closely tying a stock price to its company’s performance is an investment. In contrast, buying a stock in hopes of the price increasing is much closer to gambling.
Why Gamblers Are Drawn to Finance
The financial markets serve important purposes beyond the financial returns. They’re places to invest in the future and spread risk across many investors, making greater investments in companies possible.
However, financial markets are also attractive venues for gamblers, who only see dollar signs and increasing prices. Compounding the attractiveness are the stories that permeate the finance industry. As Shiller notes about gamblers:
“When gamblers are heard talking, they are usually telling stories, not evaluating probabilities, and the possibilities suggested by the stories often seem to have more substantive reality than any quantitative concepts.”
Is justifying a bet with a story about a string of good luck so different from justifying a stock purchase with a story about the exceptional nature of the American economy? There’s no reason to think so from a gambler’s perspective.
Shiller’s book focuses on the stock market, but the modern environment of cryptocurrencies and easily accessible speculative investments is a gambler’s playground. So, Shiller’s observation about investors who are overconfident in the stock market applies to many traders in other markets:
“Investors have also lost sight of another truth: that no one is guaranteeing that stocks will do well. There is no welfare plan for people who lose in the stock market.”
Not All Crowds are Wise
Shiller published Irrational Exuberance in 2015, five years before the COVID recession and about six years after the Great Recession ended in mid-2009. It was a period of economic optimism. Both Presidents Obama and Trump oversaw strong economies between crashes, but downturns still wipe traders out who aren’t paying attention to their portfolios.
In Irrational Exhuberance, Shiller attributed high stock prices to attitudes rather than careful analysis of the performance of each company:
“The markets have been high because of the combined effect of indifferent thinking by millions of people, very few of whom have felt the need to perform careful research on long-term investment value, and who are motivated substantially by their own emotions, random attentions, and perceptions of conventional wisdom. Their all-too-human behavior has been heavily influenced by news media that are interested in attracting viewers or readers, with limited incentive to discipline their viewers or readers with the type of quantitative analysis that might give them a correct impression of fundamental value.”
The “wisdom of crowds” doesn’t guarantee that any group’s aggregation of a value will be correct. Instead, it lays out the conditions a crowd must meet to be considered “wise.” Shillers argument in 2015 was that the market highs were not the result of a wise crowd, but rather influenced by irrational forces like stories fuelling optimism rather than analysis.
That doesn’t financial markets are wholly irrational or only gambling platforms. It does mean there is significant gambling activity and irrationality within the markets, and anyone analyzing them must take these forces into account.