Irrational Exuberance: Definition, Origin, Example

irrational exuberance meaning

The height of the bubble was between 1634 and 1637, when tulips went for 10,000 guilders, roughly the value of a mansion on the Amsterdam Grand Canal. The rarest bulbs traded for six times the average person’s salary. Irrational exuberance irrational exuberance meaning in investing can crush your long-term gains and rational planning. Here’s what investors need to know so they don’t fall victim to the hype. This website is using a security service to protect itself from online attacks.

While it may be tempting to ignore warning signs, you should always watch economic indicators. Even if an asset seems to have meteoric growth, if the price doesn’t match the underlying value, it will eventually crash. And if the indicators say the market isn’t as strong as it looks, you shouldn’t let yourself slip into a herd mentality and place your money on a sinking ship. Then confidence crumbled, and the market collapsed, sending prices crashing back down to earth and leaving investors unable to sell bulbs for even a fourth of what they paid. It wasn’t devastating for the economy, but it did undermine social expectations, namely the previous trust in other people’s ability to pay. It may even look like prices are rising for valid reasons.

The bursting of the oil price bubble was in part in response to irrational exuberance in the U.S. dollar. Investors increased the dollar’s strength by 25% in 2014 and 2015. It affected manufacturers’ exports by giving an artificial boost to their prices. As a result, they sink more money into investments with ever-deteriorating returns. Irrational exuberance can only occur during the later expansion phase of the business cycle. That’s when the economy has been running at full capacity for a while.

Law & Fin. Markets Rev.

Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem. A well-publicized pithy maxim about the stock market in the late 1990s. Alan Greenspan was Chairman of the Fed in those heady days, and he couldn’t figure out why stocks traded at such high multiples relative to their earnings. Or maybe he was just torqued because his buddies were making the sick money and he wasn’t.

  • And because investors are desperate for more new growth, they sink money into whatever asset happens to be rising without inspecting possibly deteriorating returns or poor economic fundamentals.
  • Referred to as a state of frenzy, irrational exuberance means that traders’ enthusiasm for an asset is more positive than can be fundamentally justified.
  • Fortunately, it didn’t spread to the rest of the economy.
  • Local cultivators figured out that a tulip could grow from seed or from buds that grew on the mother bulb, and while it took seven to twelve years to grow a tulip from seed, a bulb could flower the very next year.

We then present our field study and analyze our results. We conclude by examining the limits and potential of our research effort. Irrational exuberance happens when investors look at positive signals and egg each other on. As Greenspan argued, they become complacent in the expectation that good times will last, and in their rush for profits, they overlook deteriorating economic fundamentals and bid ever higher, creating a bubble. As there is no fundamental reason for the higher asset prices, it will eventually burst and go into market correction, resulting in a panic sell-off.

But, when the ultimately bubble bursts, investors quickly turn to panic selling, sometimes selling their assets for less than they’re worth based on fundamentals. The panic that follows a bubble can spread to other asset classes, and can even cause a recession. The investors who get hit the hardest — the ones who are still all-in just before the correction — are the overconfident ones who are sure that the bull run will last forever. Trusting that a bull won’t turn on you is a sure way to get yourself gored.

Irrational exuberance

Fed Chair Alan Greenspan first coined the phrase in a 1996 speech to the American Enterprise Institute. In «The Challenge of Central Banking in a Democratic Society,» Greenspan asked how central bankers could tell whether asset values were overpriced. For a few days, the markets collapsed, but then exuberance again took hold and the markets continued their rise. As an investor, irrational exuberance can spell disaster for your portfolio. And you can’t let yourself fall victim to the pull if you want to protect your long-term gains. This created growing demand for the rare broken bulb, and it became all the rage in Holland to own tulips.

  • In response, the People’s Bank of China lowered the yuan’s value by 3% in August 2015.
  • Investors follow each other into whatever asset is rising.
  • Irrational Exuberance is also the name of a 2000 book authored by economist Robert Shiller.
  • This produced “broken bulbs,” a type of tulip with a multicolored pattern rather than the solid-color imported flowers.

They become so greedy for profits that they overlook deteriorating economic fundamentals. They get into a bidding war and send prices up even higher. Irrational exuberance is widespread and undue economic optimism. When investors start believing that the rise in prices in the recent past predicts the future, they are acting as if there is no uncertainty in the market, causing a positive feedback loop of ever-higher prices. «Irrational exuberance» is a phrase used by Federal Reserve Board Chairman Alan Greenspan in a speech given during the stock market boom of the 1990s. The phrase was interpreted by financial pundits as a typically cryptic warning that the market might be overvalued.

From the horse’s mouth: economic conditions and investor expectations of risk and return

And as the irrational exuberance investing definition shows, many people ignore logical signals in favor of profit that doesn’t have a basis in real value. The same buyers who initially were overly enthusiastic about the asset’s growth will sell the asset ultimately pushing its price below intrinsic value after the bubble burst. Traders purchase more quantities of a stock, assuming its value has potential to grow.

Investors follow each other into whatever asset is rising. It usually occurs in stocks but has also happened in housing, gold, or even Bitcoin. One of the most famous market bubbles and crashes of all time is the Dutch tulip market bubble, or tulip mania. This occurred in Holland between the early to mid-1600s during the Dutch Golden Age. This process can only occur in the later expansion phase of the business cycle.

Fortunately, it didn’t spread to the rest of the economy. At the time, tulips were a luxury item, providing a sense of exoticism because they didn’t look like any other native flower on the continent. Yet they were also notoriously fragile and difficult to grow.

Then professional traders got in on the action, and people began buying tulips with leverage, hoping to pay off their debts once they sold the bulbs for a profit. Basically, investors get so confident that they lose sight of what an asset is actually worth. This means that they’re buying into a bubble, and eventually, the larger market will catch up, and the bubble will burst.

Hyperbolic discounting and consumption

The demand and supply forces for a particular stock or asset determines its market value. However, sometimes the market value of an asset can appear exaggerated as a result of irrational exuberance among traders. Greenspan’s use of the phrase «irrational exuberance» sent stock markets plummeting the next day. Investors were afraid that the Fed would raise interest rates to slow down the economy. Investors egg each other into a state of irrational exuberance.

irrational exuberance meaning

Fed Chair Alan Greenspan warned the markets about their irrational exuberance on December 5, 1996. But he did not tighten monetary policy until the spring of 2000, after banks and brokerages had used the excess liquidity the Fed created in advance of the Y2K bug to fund internet stocks. Having poured gasoline on the fire, Greenspan had no choice but to burst the bubble. And because investors are desperate for more new growth, they sink money into whatever asset happens to be rising without inspecting possibly deteriorating returns or poor economic fundamentals. If they stuck to the fundamentals, they would reject bad investments and keep their cash, but because they’re desperate for more growth, they turn to any shiny asset that might present an opportunity. In the next section, we examine the literature on the five variables of interest.

Discussion

He then asked whether central banks should address irrational exuberance with monetary policy. At the time, the Fed didn’t concern itself with the stock market or even real estate prices. He did note though, that central bankers must get involved when they sense that speculative frenzy is driving a dangerous bubble. He concluded that when the stock market or any asset class affects the economy, then central bankers must get involved. It is believed to be a problem because it can give rise to bubbles in asset prices.

irrational exuberance meaning

As a result, the frenzy of greed turns to panic when asset prices return to their real-world values. «Irrational exuberance» is the phrase used by the then-Federal Reserve Board chairman, Alan Greenspan, in a speech given at the American Enterprise Institute during the dot-com bubble of the 1990s. The phrase was interpreted as a warning that the stock market might be overvalued.

In investing, irrational exuberance is when investor confidence drives asset prices higher than their fundamentals logically justify. It’s best understood as a kind of mania—investors are so confident that an asset will keep rising in value that they completely lose sight of the asset’s intrinsic value. Alan Greenspan raised the question of whether central banks should address irrational exuberance via a preemptive tight monetary policy. He believed that central should raise interest rates when it appears that a speculative bubble is beginning to take shape.

Due to the herd bias, as the asset value rises higher more and more traders tend to follow the suit driving the price further up to surpass the asset’s intrinsic value and form a bubble. Stock market movements are broadly dependent on the behaviour of traders, who buy and sell stocks aiming to profit from price fluctuations. Greenspan noted that low-interest rates had created steady earnings.

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The world stock market is a set of exchanges and markets… Irrational exuberance is defined by an overinflated asset value caused by increased enthusiasm among traders without any rational reasons backing the positive market sentiment. The strong dollar also drove up the value of the Chinese yuan, which was pegged to the dollar. In response, the People’s Bank of China lowered the yuan’s value by 3% in August 2015. That triggered a Chinese stock market crash and raised concerns of currency wars. The stock market crash that followed erased more than four years of gains in the tech-heavy Nasdaq composite index and wiped out many billions of dollars in market capitalization.

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