I’ve posted Column Entry #8 to my weekly Valuation-Informed Indexing column at the Value Walk site. It’s called Emotional Market Theory.
Juicy Excerpt #1: I am in complete agreement with Bogle that the loss of market capitalization that we saw during the price crash was irrational; nothing happened in the world over the course of that year to justify the loss of $8 trillion in market capitalization. However, I believe that Bogle came to an entirely unwarranted conclusion about this irrationality.
The irrationality that evidenced itself should not have been reassuring to Buy-and-Hold investors (the investors most interested in hearing Bogle’s take). It should have scared them to death. Bogle, the lead advocate of an investing strategy rooted in a belief that prices are set rationally, was saying that prices are in fact irrational. The logical conclusion to be drawn from Bogle’s statement is that the lead advocate of Buy-and-Hold has lost confidence in its core premises. That’s disturbing in the extreme, not even a tiny bit reassuring.
Juicy Excerpt #2: The difference between believing that stock prices are the result of reason and believing that stock prices are the result of emotion is stark. Making the switch from one to the other changes the nature of the analysis performed in a fundamental way. It’s like the difference between believing that the words of every character in a play are an accurate reflection of his or her plans and motives and understanding that some people are deliberately saying the opposite of what they feel as part of an effort to deceive others or perhaps even themselves. Shiller is pointing us to a more mature and sophisticated and realistic way of understanding how markets work.