By John De Goey, CFP, CIM

Special to the Financial Independence Hub

The word “bubble” is bandied about often to explain quick and often unwarranted run-ups in securities prices.  If you use the word in that context in a general conversation about economics, most people will have a quick, intuitive understanding of what you’re talking about.

Interestingly, two of the most prominent financial economists have radically different definitions of the term.  In fact, one of them goes so far as to suggest that the word “bubble” is itself a misnomer that is all but meaningless.

A half dozen years ago, Professors Robert Shiller of Yale and Eugene Fama of the University of Chicago shared the Nobel for their contributions to the understanding of asset pricing.  Many people have since speculated that the people in Stockholm who award the prize chose to give it to the two men concurrently in order to avoid implicitly “taking a side” in the debate about what constitutes bubbles.  While I respect and admire both men immensely, you need to understand that they are rivals of sorts.  The Nobel people likely wanted to recognize both without getting involved in a political and sometimes dogmatic battle of wits.

For about a generation now, I’ve been using products based on Fama’s research as the primary set of core holdings for my clients.  Based on a recent conversation with one of that company’s representatives, that’s about to change.  Basically, the company threatened to stop working with me simply because I told them I was inclined to subscribe to Shiller’s definition of a bubble.

Irrational exuberance

I’m currently reading the third edition (2014) of Shiller’s groundbreaking book “Irrational Exuberance.”  He gets straight to the point.  In the preface, he writes:

Maybe the word bubble is used too carelessly.  Eugene Fama certainly thinks so.  Fama, the most important proponent of the “efficient markets hypothesis,” denies that speculative bubbles exist.   In his 2014 Nobel lecture, Fama states that the word bubble refers to “an irrational strong price increase that implies a predictable strong decline.”  If that is what bubble means, and if predictable means that we can specify the date when a bubble bursts, then I agree with him that there may be little solid evidence that bubbles exist.  But that is not my definition of a bubble, for speculative markets are just not so predictable.

Obviously, it’s all fine and well for Shiller to say what a bubble isn’t, but it should be obvious that it behooves him to go on to offer what his own definition might be.  He provides a concise explanation (definition?) in chapter 1:

Irrational exuberance is the psychological basis of a speculative bubble.  I define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, and, in the process, amplifies stories that might justify the price increase and brings in a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.

Basically, I agree with Shiller on both counts … that Fama’s point is fair if one’s definition implies predictability, but that Shiller’s point (and definition) is more practical.  I certainly do believe that bubbles exist and I make absolutely no claim to be able to predict anything about when, how or why they will burst. Continue Reading…