Irrational Exuberance
Candlefocus EditorOne of the most widely recognized usages of the term ‘irrational exuberance’ comes from the 1996 Federal Reserve Chairman Alan Greenspan. In a speech delivered to the National Association of Business Economics he expressed concern about the overheated valuations of certain stocks that displayed no correlation to traditional, fundamental means of calculating assets such as earnings, cash flow and assets. Greenspan served as an early warning to investors that the market was experiencing excess excitement as he saw that the prices of these stocks were unjustifiably inflated—setting off a chain reaction that led to subsequent market corrections.
Irrational exuberance is often fueled by psychological factors. Warped perceptions, misconception, and herd mentality can all have a role in the formation of bubbles. Investors tend to blindly follow the decisions of those who came before them for fear of missing out on big gains. This can lead to overpriced investments as more investors jump on the bandwagon, creating a self-fulfilling bubble.
The bursting of a bubble created by irrational exuberance can have devastating consequences, depending on the size of the bubble and the overall effect of the popping. It may not just be investors who suffer if a large enough bubble breaks. The entire market can be impacted by the bursting of the bubble—spreading shockwaves across the economy and wiping out vast amounts of wealth.
Irrational exuberance can be avoided by taking calculated risks, educating yourself on the fundamentals of investing, and developing strong analytical skills. Investment decisions should be based on solid analytic data that provides a deeper understanding of the underlying fundamentals of the asset. Irrational exuberance can also be avoided if investors become more aware of the potential negative consequences of acting too quickly. Taking the time to carefully analyze potential investments will help ensure that each decision is made with the maximum benefit for the investor.