Irrational Investors Don’t Exist

Robert Shiller says we’re in a tech bubble

But wasn’t the alleged tech bubble supposed to have burst in 2012? Oh well, chalk that up as another incorrect liberal prediction.

Eugene Fama and Robert Shiller were awarded the 2013 economics Nobel Prize, despite holding opposing views of the market. Shiller, a pioneer of behavior finance, says markets can exhibit irrationality and bubbles can possibly be predicted. Fama, the originator of the efficient market hypothesis, believes markets are rational and bubbles do not exist, which preludes any ability to predict them.

Shiller is like a showman with movie star looks. Markets are nearly impossible to predict because in retrospect many bubbles like Facebook, for example, now seem rational. It is demonstrably impossible to exploit ‘bubbles’ to achieve excess returns, even during the late 90′s. For a couple reasons: liquidity and timing. It’s hard to find shares to short and if your timing is bad and the stock keeps rising, you’ll get a margin call and be forced out of the position at a large loss, even if your original thesis is correct. A notable example is the Manhattan Investment Fund that lost $400 million shorting tech stocks in the 90′s. He is the real wolf of Wall St., but you won’t be seeing a movie about him because the it makes the government look incompetent being that he got away with it. In 2007, Microsoft purchased a small stake in Facebook , valuing the social networking site at $15 billion. Everyone in the media and blogs (except me and some others) was convinced it was bubble. Fast forward to 2014 and Facebook is worth north of $130 billion. Anyone went on the opposite side of that trade (assuming Facebook was a public company) would have lost 500-700% of their money.

Portfolio theory says that rational agents seek to optimize the tradeoff between risk and reward before making an investment. Prospect theory takes it step further by assuming investors are more averse to loss than gain, but nonetheless, all investors use some sort of heuristic for gauging risk/reward.

There is no such thing as ‘real time’ irrationality; only irrational behavior in retrospect. Buying pets.com? Irrational. Buying Facebook stock in the low $20′s in 2012 or Google at $50 in 2004? Rational. No one enters a trade with the intention of losing money, unless they were really irrational. But then they would also be insane, which is another matter altogether.

The Shiller PE ratio index is also of questionable value due to insufficient datapoints, overshoots, etc. You can’t use the index to extrapolate any statistically significant predictions. A PE of 40 is overvalued, but we only have one instance in history when the S&P 500 PE ratio was that high, so it’s hard to make an inference from one example.

The Shiller housing index is also useless because real estate is driven by local dynamics. Bay Area real estate was largely insulated from the 2008 crisis and was the quickest to rebound to new highs.

The belief in irrationality, bubbles, and the ‘unfair playing field’ is popular because it’s a convenient coping mechanism for reconciling one’s own mediocrity. Instead of accepting your limitations, you can just blame high frequency traders and the fed for making the market rigged in the same way that an individual that scores poorly on an IQ test can blame the test or society instead of himself for not being smart enough.