Home Stocks The Temptation to Overprice Stocks Is Ever-Present

The Temptation to Overprice Stocks Is Ever-Present

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What makes stocks risky? Most people don’t think to ask that question. The common thought is that that is just the way things are. Stocks have always been risky. There is no need to ponder the question. Stocks are risky in the way that water is wet.

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I believe that Robert Shiller’s “revolutionary” (his word) research findings should change our thinking re this matter. Shiller showed that, to the extent stock prices increase beyond what they would be if the CAPE value were 16, it is not economic advances that are behind the price increase but only an irrational exuberance that will disappear into the mist in not too long a time.

So stock overvaluation is the cause of most stock investment risk. When stocks are priced reasonably, price gains are there to stay. There can be price drops from fair-value price levels, of course. But, unlike price drops experienced at times of super high CAPE levels, those price drops are a temporary phenomenon. It is high stock prices that put investors in jeopardy of experiencing real and lasting losses. It is overvaluation that makes stocks risky. The more overvaluation there is at a given time, the more risky stocks are at that time.

So why do we see overvaluation? Why don’t investors just price stocks properly? Wouldn’t that be the rational thing to do?

It is the rational thing to do. But investors are humans and humans are not entirely rational creatures. Investors overprice stocks for the same reason why bank robbers rob banks -- that’s where the money is.

Investors don’t like to acknowledge this. When we see an increased value for our portfolio, we want to believe that the increase is rooted in something of lasting economic significance. So most of what we read about the reasons for increased stock prices points to things like greater productivity and increased consumer confidence and new means of achieving enhanced efficiencies. There’s no way to tell, of course. Some stock gains really are the result of positive economic developments. Who’s to say that all of them are not?

I find the idea that all stock gains are supported by economic realities implausible. All that stock investors need to do to push their portfolio value higher is to bid up the price of stocks. The money is there for the taking. Why would they not do this? The default belief should be that of course investors create phony gains through overvaluation.

We should be willing to question that belief only in cases where evidence is presented that stock gains represent something real. Such evidence exists when prices are at fair-value levels or lower. In those cases, Shiller’s research shows that the long-term gains are likely to be in the neighborhood of 6.5 percent real or better. That’s not the case when prices rise to the level where they reside today. So why believe that there is something other than a widespread investor desire for something-for-nothing at work?

The Temptation To Overprice Stocks

The temptation to overprice stocks is ever-present. And that temptation hurts investors in very serious ways in the long run. At times of overvaluation, investors do not know the true and lasting value of their stock portfolios. That makes effective financial planning impossible. And of course overvaluation brings on price crashes and the economic crises that follow from it, which cause millions of retirements to fail and millions of workers to lose their jobs.

We should be fighting our urge to overprice stocks. How could we go about doing that? Through market timing. That’s the answer. That’s the only way. If we all lowered our stock allocation when prices got too high, stock prices would become self-regulating. High levels of overpricing would become a logical impossibility. And all of the risk that is associated with high levels of overpricing would become a thing of the past. Stocks would become a far more appealing asset class and our economic system would function far more smoothly.

Shiller’s project is to change the behavior of stock investors. I am not aware of him ever putting it quite like that. But that is the “revolution” to which the subtitle of his book refers. When we acknowledge the power of irrational exuberance to do harm to all of us, we will all pull together to rein in the natural but unfortunate human temptation to push stock prices to absurd and unsustainable levels.

Rob’s bio is here.

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