Investors are mentally ill – Nobel Laureate

Nobel Laureate in economics Robert Shiller spoke at the AAII investor conference this month where he quoted Keynes on investing: "Most probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction."

Keynes thought investors were driven by animal spirits. Shiller has even a lower opinion of investors. He said at the World Economic Forum held in Davos, Switzerland in 2010 that hecould identify bubbles using the same methods that psychologists use to diagnose mental illness in patients. His key points were these:

1. Sharp increase in the price of an asset.

2. Great public excitement about these price increases.

3. An accompanying media frenzy.

4. Stories of people earning a lot of money, causing envy among people who aren’t.

5. Growing interest in the asset class among the general public.

6. New era “theories” to justify unprecedented price increases.

7. A decline in lending standards.

Great Expectations part II

The previous post introduced the concept of elasticity of expectations as developed by Ludwig M. Lachmann and applies it to the stock market. Lachmann added that the velocity of price change is important as well as the practical range and break outs from the range: 

“‘Explosive’ price change is seen to be the main cause of elastic expectations, both in the sense of violent change, and in that it destroys the existing basis of expectations, the sense of normality, which provided a criterion of distinction between the more probable, the less probable, and the highly improbable. It does so by demonstrating that the highly improbable, which had been excluded from our range, is possible after all. Now, as we saw, a price will pass the limits of the range with difficulty. As it approaches them it encounters increasing pressure from inelastic expectations resulting in sales at the upper and purchases at the lower limit. To overcome the pressure of these stabilizing market forces the price movement will most probably have to be carried by a strong ‘exogenous’ force, i.e. one originating outside the market, unknown to it and therefore not taken into account when expectations were formed.”[1]