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Irrational Exuberance

Investor Learning And Unlearning

According to the efficient markets theory, the market is higher today because the public has now learned simple facts about historical average returns and diversification. This argument differs from the efficient markets argument in supposing that the market was previously priced too low due to public ignorance. Society has now learned that the stock market is much more valuable than it was once thought to be.



People have recently discovered that the stock market is a much more secure investment than they once thought. This "learning" is apparently the result of widespread media coverage about the historical superiority of stocks as investments and of the publication of Jeremy Siegel's Stocks for The Long Run in 1994. Armed with this new knowledge, investors have now bid up stocks to a much higher level. The old prejudice against security markets and the fear of them were largely dispelled by public education regarding stocks and bonds. Three major peaks of the price-earnings ratio have also been identified - peaks in June 1901, September 1929 and January 1966. In each of the twenty-year periods following these peaks, the stock market has performed poorly in real (inflation-corrected) terms.


Today, we have long-term inflation indexed bonds yielding over 4%, guaranteed against the effects of inflation. The proof that stocks will always outperform bonds over long time intervals simply does not exist. It could be that, with investors invigorated by past successes in the stock market, there is now far-flung over investment. Given the high price-earnings ratios mentioned previously, the market is more highly priced than ever before. Stocks are therefore, by the very definition, risky.



Knowledge about the long-run historical records that dates back to at least 1924 cannot be held directly responsible for the sudden upsurge in stock prices to record levels in the late 1990s. The public's belief that any downturn in the market will soon be reversed has gained remarkable strength in recent years. This confidence derives from such things as a feedback mechanism from past price increases.



It was noted that the investors had become much more educated about stocks due to mutual funds and the media. They learned to hold stocks for long terms and see price declines as temporary and as buying opportunities. Investors had learned that diversified portfolios of stocks are not risky. However, it should also be noted that stock market declines can persist for decades and thus, even the long-run investors should see risk in stock market investments. In response to heightened investor interest, the mutual fund industry has brought forth thousands of new funds, with a constant proliferation of ads and mailings.



It seems that the public has learned that stocks always go right back up after they go down. However, stocks can go down and become overpriced and underperform for many years altogether. The public is said to have learned about the wisdom of investing in stocks via mutual funds whose management teams have proven track records. Picking mutual funds that have done well give much smaller benefits than investors imagine. Someday, investors might 'unlearn' these facts.

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Units 11/13