I have taken a keen interest lately in Behavioral Finance, which is basically how emotion and psychology influence our money and investing decisions. A book I am reading about the subject is by Robert Schiller an Economist at Yale that has done extensive writing on the topic. His book "Irrational Exuberance" first came out in early 2000, near the peak of the Tech Bubble. He followed up with a second edition in 2005 incorporating real estate into the theme. The book takes on the topic of why "bubbles" form in markets and morphs into the fact that despite knowing better that we as human beings get caught up in a feedback loop that propels bubbles higher and higher, until eventually they pop. He sites some interesting examples as to how emotion and positive psychology (as in the good times will never end) can make us do completely irrational things when it comes to investing. One that really nailed this point was when Etoys.com went public in the late 90's. It's market cap was $8 billion vs. a $7 billion market cap for well established toy retailer Toys R Us. This despite the fact that Etoys.com had a couple hundred million in sales and no earnings vs. Toys R Us having over $10 billion in sales and very good earnings. Everyone was caught up in the internet craze and this excitement fed on itself. Investors wanted a piece of the action, Analysts put sky high valuation targets on these New Economy companies based on this momentum and the feedback loop perpetuated itself. This until something caused a tipping point and reality set in. We know better, but fundamentals are things that can get cast aside as emotion takes over. This is one reason I don't follow the Efficient Market Theory, which states that all assets are accurately priced and reflect all known information. This concept would require human beings to be always be rational when it comes to money.
As I was wrapping up this newsletter an email hit my inbox from a blog I follow. Many of you have heard of Mark Cuban, the very outspoken owner of the Dallas Mavericks and billionaire founder of multiple tech companies. He keeps a blog that details his start in business along with other thoughts on the world. This latest blog entry was a rehash of one he posted in 2004 about his experience in the stock market as a trader/investor. It's a critique on Wall Street, which is much deserved but I thought that it tied in nicely with this whole Behavioral Finance topic, so wanted to share the link:
I hope you enjoyed this months newsletter. If you have any questions about planning or investing feel free to drop me an email:
James A. Daniel, CFP®
Disclaimer: this information is for general purposes and should not be considered tax advice. Talk with your accountant and/or advisor before implementing!