The Far-Reaching Economic Implications of Shiller’s Research

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Say that you own a bowling alley. You need to make decisions about how many employees to have on staff next year and on how much money to direct to advertising and on how much you can charge per game and still expect to be able to earn a profit. There are lots of places to which you can turn to get the information you need to help you make these decisions. You have your records from last years. You have data on demographic trends in your area. You have journals in your field reporting on how bowling is becoming a more or less popular entertainment option.

There’s one source of information that you need to take into consideration but that you might not think to consult: Robert Shiller’s book Irrational Exuberance.

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That’s an investing book! What can an investing book reveal about how to run a bowling alley?

It can reveal a lot. The title of Shiller’s book is profound. When he describes stock market gains above those that would apply if the market were priced properly as the product of irrational exuberance rather than as the product of a rational assessment of economic realities, he is saying that those amounts are not real. Stocks are today priced at two times fair value. So Shiller is saying that half of the money that today’s investors are counting on to finance their retirement represent nothing more than cotton-candy nothingness fated in time to be blown away in the wind.

Changes In The Popularity Of Competing Entertainment Options

That’s a reality with far-reaching economic implications. If half of the money in our stock portfolios is going to disappear (irrational exuberance has always eventually disappeared during the 150 years of stock market history for which we have good records), we are not going to have as much money to devote to discretionary entertainment expenses like bowling. The loss of that money will have a bigger effect on how many people go bowling in the future and on how much they will be willing to pay to do so than demographic changes or changes in the popularity of competing entertainment options like going to the movies or enjoying a casual dining-out experience.

The proprietors of bowling establishments consider demographic changes and changes in the popularity of competing entertainment options when making decisions as to how to run their businesses. They do not take Shiller’s research findings into consideration. Why?

Shiller’s research findings represent a revolutionary change in how our economy works. In pre-Shiller days, we thought of the numbers listed on our portfolio statement as real. They sure seem real. If you ask to cash in your stock holdings, you will be paid the full amount listed on the statement. That suggests that those numbers are pretty darn real, does it not?

Shiller is saying otherwise. He is saying that some of your stock portfolio is real, the amount that reflects the fair-value price for the stocks you hold is real. But he is also saying that the amount by which the nominal value of your holdings exceeds their fair-value price is the product of irrational exuberance and not real and lasting but fake and temporary.

The Irrational Exuberance Factor

It’s tricky knowing when to take the irrational exuberance factor into consideration when running a business. It can take 10 years or more for irrational exuberance to disappear. So, if you make business plans based on the irrational exuberance present in the market price today, those plans may be off the mark. The other side of the story, of course, is that, if you make plans that ignore the irrational exuberance factors, your plans may be even more off the mark. The most prudent course of action is to accept that the risk of the disappearance of the irrational exuberance is greater the more that stocks are overpriced and the longer that they have remained overpriced while also understanding that precise predictions of when the disappearance of irrational exuberance will come to have economic significance are not possible.

The issue here of course applies to all businesses, not just to any one bowling establishment. When people see a large portion of their life savings disappear, they spend less. When stock prices fall hard, we all see a large portion of our life savings disappear. All of us who care about the ongoing success of U.S. businesses should be doing what we can to insure that stock prices never get so high as to make the sudden disappearance of a large amount of irrational exuberance a likely possibility.

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About the Author

robbennett
Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”

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