Irrational Exuberance

Article byPrakhar Gajendrakar
Edited byRaisa Ali
Reviewed byDheeraj Vaidya, CFA, FRM

Irrational Exuberance Meaning

Irrational exuberance refers to the enthusiasm or optimism exhibited by the investors without going for rational thinking, causing an exponential rise in asset prices. The increase in asset price usually will not have a positive correlation with its intrinsic value.

The American economist and the former chair of the Federal Reserve, Alan Greenspan, used this in one of his speeches as a phrase to point the existence of stock marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific more overvaluation during the internet or dot-com bubbleDot-com BubbleThe Dotcom Bubble was an economic bubble that affected the prices of stocks related to the technology industry during the late 1990s and early 2000s in the United States. The event was triggered by the hype over the new Internet industry, media attention, and investors’ speculation of profits by dot-com more of the 1990s. The plummeting of the Tokyo market on the day of the speech exemplified how the various markets reacted to this news.

Key Takeaways

  • Irrational exuberance refers to the intense enthusiasm of investors influencing investment decisions and driving the asset prices to a value more than the value based on its fundamental analysis.
  • It causes asset price bubbles manifesting exceptional price growth with no reason but investor enthusiasm backed by optimism.
  • The tulip bubble of the 17th century, railway mania in Great Britain (1840s), the financial crisis of the 2000s in the US are historical examples of it.
  • The irrational exuberance book by Robert J. Shiller gives a broad perspective on the same topic.

Irrational Exuberance Explained

Irrational exuberance is an example of how human psychology influences the financial marketFinancial MarketThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market more, specifically the stock market. A highly volatile nature is an important aspect of any stock market. A single piece of news, new investment opportunity, or success of other investors can trigger the enthusiasm in investors, as in the case of cryptocurrencies Cryptocurrencies Cryptocurrency refers to a technology that acts as a medium for facilitating the conduct of different financial transactions which are safe and secure. It is one of the tradable digital forms of money, allowing the person to send or receive the money from the other party without any help of the third party moreand meme stocksMeme StocksMeme stocks attract retail investors through social media debates, leading to a surge in prices and trading more like Gamestop and AMC. Likewise, investors’ confidence started by the desire for higher potential returns makes them join the bandwagon and create a speculative bubble. It happens despite strong fundamentals backing the stocks.

Irrational Exuberance

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This exuberance can be caused by factors like feedback based on past data and a speculative bubble. When affected by exuberant movements, the investors are deluding that the price will increase or the uptrend will continue for a long time. If the price keeps rising, the exuberance effect will get stronger. Often professional investors refrain from this kind of unjustified optimism compared to nonprofessional or retail investors. However, professional investors are not completely resistant to it.

When the price growth is not backed by strong fundamentals or not in line with the intrinsic valuesIntrinsic ValuesIntrinsic value is defined as the net present value of all future free cash flows to equity (FCFE) generated by a company over the course of its existence. It reflects the true value of the company that underlies the stock, i.e. the amount of money that might be received if the company and all of its assets were sold more, the bubble eventually bursts. There is a panic situation in the market; like in the exuberance scenario, investors’ decisions attract one another. Investors sell their assets even at lower prices disrupting the market and spreading the effect to other financial markets leading to recessionRecessionEconomic recession is defined as the phase in which economic activities of a country become stagnant, leading to a disturbance in the business cycle and affecting the overall demand-supply balance. read more. Hence, it is evident that this high valuation period does not have any long-term positive impact. Any small factor like negative earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other more in a quarter or lawsuit news can cause the price drop.

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Irrational exuberance is common in stock markets since psychology plays an important role in the stock market investment decisions. These decisions are backed by various biases against rational thinking and explain the gap between theory and practice. In the stock market, the exuberance movements are not limited to the cases of meme stocks but others like consumer discretionaryConsumer DiscretionaryConsumer discretionary refers to goods and services mostly acquired using discretionary income as they are optional in people’s lives such as designer clothes or luxury more stocks such as Netflix and Amazon also.

Let’s look into the example of the Reddit Rebellion contributing to the uptrend, which also signals the exuberance movement. The Reddit Rebellion focuses on buying the stocks subjected to shorting by professional traders and holding them for a significant period rather than selling them. As a result, it contributes to or creates an uptrend. 

In 2021 February, the Reddit Rebellion effort got backstopping due to favorable government settings or Fed policy formulated to push the economy and liquidity, exemplifying the invisible forces. Furthermore, the trading platform Robinhood removed the constraints placed on Reddit-fueled stocks like Gamestop. It indicates excessive speculations and causes a rise in such stock prices, forming price bubblesPrice BubblesA price bubble occurs when the price of an asset, such as a stock or a commodity, is overbought, or when demand for such asset is constantly increasing, resulting in a price rise that exceeds the asset's explainable fair more

Book on Irrational Exuberance (by Robert Shiller)

Irrational Exuberance Book is written by famous American Economist and the Nobel Prize winner Robert J. Shiller. The first edition was published in 2000, followed by the second edition in 2005 and the third edition in 2015. The book further popularized the phrase and ideology coined by Alan Greenspan.

Various editions primarily interpreted the high valuation seen in various financial markets in the United States, its consequences, and suggestions, including the policy amendments to deal with the booms. The first version covered the stock market bubble, the second version focused on the housing market bubbleHousing Market BubbleA housing bubble is a duration in which the cost of houses and other real estate properties increases dramatically at the local or global level. The prices can continue to grow at any time until the supply eventually catches up. The trend can end with a sudden drop in house prices, causing the bubble to more, and the third edition included the bond market scenario. The first two versions predicted the corresponding crashes also. It explained how the high prices filling the financial markets would plummet using structural, cultural, and psychological factors contributing to the price growth.

Frequently Asked Questions (FAQs)

What is irrational exuberance?

Irrational exuberance occurs when the investors exhibiting high excitement and interest go for the purchase of an asset based on its current high performance without considering its intrinsic value. Subsequently, this leads to the increase in asset price irrational with its real value.  

What is an example of irrational exuberance?

In the early 2000s, the collapse of the US housing bubble alongside the downfall and bankruptcy of Lehman Brothers, one of the major investment banks, intensified the 2008 financial crisis. The housing bubble formed due to exuberant movement caused by easy credit availability, relaxed lending policies, and cash inflow into the housing market; people started investing heavily in it and believed it would never decline.

Who said irrational exuberance?

At the American Enterprise Institute, during the speech regarding the dot-com or internet bubble of the 1990s, usage of the phrase “irrational exuberance” Alan Greenspan, the American economist and the former chair of the Federal Reserve, intended to alert people about the presence of market overvaluation. Later the famous book “Irrational Exuberance” by Shiller, published in 2000, became a wide perspective point of view and study material of the subject.

This has been a guide to Irrational Exuberance and its Meaning. Here we discuss the Book on Irrational Exuberance and its explanations and examples. You can learn more from the following articles –