If you were to Google “classic finance books every investor should read,” you’ll find Irrational Exuberance by Nobel Prize winner Robert Shiller on many lists. The third edition hit bookstores in 2016.
When the first edition was published in 2000, it immediately hit the New York Times best-seller list, in part because Shiller’s research challenged the Efficient Market Hypothesis (EMH).
Widely accepted by many when Eugene Fama published the first definitive work in 1970, EMH is an investment theory that states it’s impossible to beat the markets because stock market efficiency causes share prices to always incorporate and reflect all relevant information. Shiller’s premise: The theory does not explain why the stock market can go through periods of significant mispricing lasting years and decades.
Is It Still Relevant?
Shiller’s updated edition shows that this and the other themes of the book remain just as relevant today as they were when the first edition was published 18 years ago. Market events since 2000 — take the housing bubble for example — confirm the validity of Shiller’s basic premise that markets can be bid up to unusually high and unsustainable levels under the influence of market psychology.
The fact that these “bubbles” — when unsubstantiated mass enthusiasm for one kind of investment temporarily inflates prices to an unsustainable level — exist and can drive the economy is not disputed by history or most experts.
Shiller provides a list of learned, yet invalid, guiding principles that seem to drive the behavior of stock market investors. The public has learned that
(1) stocks always go right back up after they go down,
(2) stocks must always outperform other investments (long-run investors will always do best), and
(3) investing in stocks via mutual funds is always wise.
Shiller points out and backs up with research a warning that should give all investors pause: These principles have little support in fact.
Yet this sort of group thinking “can infect even the smartest people, thanks to overconfidence, lack of attention to details and excessive trust in the judgment of others, stemming from a failure to understand that others are not making independent judgments but are themselves following still others — the blind leading the blind.”
What Does Shiller Recommend?
Pointing out some not-so-surprising trends — that people aren’t saving enough for their future, and stocks are still trading at P/E levels that are far higher than their historical averages — Shiller provides general advice for individual investors: Don’t be lulled into complacency by past investment successes, and don’t expect the level of returns we have seen in the past few years to continue.
If Shiller’s book did provide a recommended investment strategy, it might be a cross between contrarian investing and value investing. In broadest terms, contrarians follow an investment style that goes against the prevailing market trends by buying assets that are performing poorly and then selling when they perform well.
History shows that the most successful investors, like Warren Buffett, are “value investors.” They pick a portfolio of profitable companies that are underpriced by conventional measures, securities that are cheap relative to the value of the company. The characteristic of value investors is they pull out of overvalued individual stocks but not out of the market as a whole when it appears overvalued.
Shiller lays out the pitfalls of investing in stocks at times of high P/E ratios (like the market is experiencing now) and the wisdom of investing in times of economic upheaval, as well as in value stocks that offer consistent earnings and dividends.
In his final chapter, Shiller proposes economic fixes aimed at lawmakers, advisors and institutions, some tried and some new. What’s lacking, and understandably because it’s not the stated goal of the book, is recommendations about what an individual investor should do given the premises set forth in the book.
The closest the book comes to recommending a path for individual investors is found in Chapter 11: “Certainly avoiding investments that have become so overpriced that only the zealots own them is a sensible strategy.”
I completely agree this book belongs on a top 10 list of investor classics. It provides a researched understanding of human behavior in relation to economics and finance. The central theme is that asset classes will become overvalued, sometimes hugely, and we can use long-term historical data to gauge the degree to which this happens. The same data can help us predict when we can expect strong future returns, for example, when we’re at the bottom of a crisis. Understanding this is important to investors because it’s difficult to recognize a bubble when you’re in it.