Irrational exuberance, a term popularized by Nobel laureate Robert Shiller, describes how stock prices often rise far beyond their true value, driven by investor optimism rather than economic fundamentals. Shiller’s research highlights that this overvaluation is fleeting and can be detrimental to investors.
One of the key criticisms of the Buy-and-Hold strategy is its disregard for this exuberance. This approach doesn’t incorporate market timing based on valuations, which is essential to mitigating the risks associated with irrational exuberance. Despite the evidence presented by Shiller, many financial advisors remain hesitant to adopt valuation-based strategies, partly because of the potential conflict between educating clients on these risks and maintaining client satisfaction.
Shiller’s work demonstrates that when stock prices exceed the fair-value CAPE ratio of 17, the gains are not rooted in economic realities but in temporary, unsustainable optimism. This irrational exuberance misleads investors into overestimating the worth of their portfolios, which can eventually result in sharp declines when prices correct to their true value.
The creators of the Buy-and-Hold strategy offered significant insights into successful stock investing, but they overlooked the dangers of irrational exuberance. Although Shiller’s findings were not available during the development of Buy-and-Hold, it’s notable that even decades later, proponents of this strategy continue to ignore the importance of valuation-based market timing, a crucial tool for controlling irrational exuberance.
This omission is puzzling, especially given the emphasis on peer-reviewed research in investment strategies. Despite the compelling evidence from Shiller, Buy-and-Hold advocates have not integrated these findings into their approach, preferring to advise consistent stock allocations regardless of market valuations.
The reality is that investment advisors are in a difficult position. While they aim to help clients achieve better investment outcomes, they also need to cater to their clients’ desires. Most investors are attracted to the promise of irrational exuberance—believing in the possibility of high returns without fully understanding the risks.
Today, with the CAPE value at 35, stocks are priced at double their fair value. Yet, many advisors continue to downplay the risks of irrational exuberance. The popularity of Buy-and-Hold persists because it appeals to investors’ desires for quick, seemingly easy gains. In contrast, a strategy that incorporates valuation-based market timing, while more effective in the long term, may not offer the same immediate allure.
Irrational exuberance gives stock investing the excitement of a high-stakes game. However, if Shiller’s research were more widely recognized, the stock market might become a more stable, less volatile environment—eliminating the boom-and-bust cycles that characterize today’s market.
Ultimately, irrational exuberance plays a significant role in making Buy-and-Hold an attractive strategy for many. Although this approach has its merits, its neglect of valuation-based market timing may expose investors to unnecessary risks. While Buy-and-Hold without valuation timing could still be effective, it would lack the short-term excitement that currently drives its popularity.