Irrational exuberance is taking over the stock market

Throughout the last year, markets have skyrocketed to new highs ignoring uncertainties and data which should impact returns

Over the summer, my 15-year old son became interested in stocks.  He has a small portfolio of stocks to watch in an account I set up for him as a minor. As an inquisitive teenager, he asks questions about the markets and investing – a lot of questions.  And as a wealth management advisor, I was eager to encourage his new interest. 

On the night of Jan. 3, the United States killed Iranian general and terrorist Qasem Soleimani on Iraqi soil.  After rising tension with Iran leading up to the death of Soleimani, experts could only guess to what extent Iran would retaliate.  The overwhelming consensus was they would retaliate, which created uncertainty across the world and with the markets.  Despite this uncertainty, the stock market increased the next day. When I came home from work that day, my son asked why the market had gone up given the events of the previous night. I explained, “The market doesn’t always make sense, but it will come back to equilibrium over time.” He accepted the answer and did not have any more questions.

On the night of Jan. 8, Iran retaliated sending dozens of missiles into an Iraqi base, home to American soldiers.  This led to greater uncertainty and instability, with questions posed about the possibility of a war with Iran.  The next day, the stock market climbed to a record high.  Once again, my son was waiting for me when I arrived home.  He asked, “Why did the market go up after Iran attacked us?”  My answer, “We are at the point of irrational exuberance.”

Irrational exuberance

Alan Greenspan, former Chairman of the Federal Reserve, is given credit for coining the phrase irrational exuberance in a 1996 speech when he said, “How do we know when irrational exuberance has unduly escalated asset value, which then become subject to unexpected prolonged contractions?”

Irrational exuberance is a state of mania when stocks increase regardless of deteriorating fundamentals or uncertainty.  When this happens, greed, overconfidence, and fear of missing out takes over the mind of investors.  What can investors do when irrational exuberance takes over the stock market?

Circle the wagons

As pioneers moved across America, they would draw a wagon train into a circle to allow the wagons to provide cover when under attack.  This was done in defense of a threat.  Investors should also circle the wagons with their portfolio after a period of extreme growth.

Every investor should have a target allocation based on risk tolerance and financial goals.  Taking this further, this target allocation should go through stress tests to measure the probability of success should there be a downturn in the market. As stock prices rise, it is extremely important to take gains and rebalance a portfolio back to the target allocation.  This allows investors to take gains and adjust their portfolio back to their familiar asset allocation target which has been tested according to their financial plan.  When the markets start to increase, regardless of fundamentals or uncertain events, it is time for investors to rebalance and circle the wagons.

There’s gold in them there hills

Investors think in the form of traditional investments, but alternative investments are an important diversifier during times of volatility.  Introducing a small percentage of gold to a portfolio during times of irrational exuberance will provide an asset class which does well during uncertainty.

 Alternative investments like gold used to only be available to endowments and large institutional investors.  With technology, alternative investments are readily available to all investors.  But investors should understand how investments like gold work and the type of accounts to place these investments prior to introducing them to a portfolio.

Take the greed away

My grandpa used to say, “Pride comes before a fall.” This can be applied to many areas of life, especially investing. Throughout the last year, markets have skyrocketed to new highs ignoring uncertainties and data which should impact returns.  So much so, my 15-year old son with six months of investing experience is questioning recent stock market increases. 

As the markets increase, investors put on blinders, become overconfident, get greedy and disregard investing principles. This all happens before the fall.  When irrational exuberance takes over and the markets seemingly increase regardless of fundamentals or current events, I go back to one of my favorite Warren Buffet Quotes, “Be fearful when others are greedy and greedy when others are fearful.” Now is the time to take the emotion out of investing, rebalance, and circle the wagons.

Categories: Finance