Irrational exuberance explained

Stock market movements are broadly dependent on the behaviour of traders, who buy and sell stocks aiming to profit from price fluctuations. 

The demand and supply forces for a particular stock or asset determines its market value. However, sometimes the market value of an asset can appear exaggerated as a result of irrational exuberance among traders. 

Irrational exuberance is defined by an overinflated asset value caused by increased enthusiasm among traders without any rational reasons backing the positive market sentiment. 

Referred to as a state of frenzy, irrational exuberance means that traders’ enthusiasm for an asset is more positive than can be fundamentally justified. 

Traders purchase more quantities of a stock, assuming its value has potential to grow. Due to the herd bias, as the asset value rises higher more and more traders tend to follow the suit driving the price further up to surpass the asset’s intrinsic value and form a bubble. 

As there is no fundamental reason for the higher asset prices, it will eventually burst and go into market correction, resulting in a panic sell-off.

The same buyers who initially were overly enthusiastic about the asset’s growth will sell the asset ultimately pushing its price below intrinsic value after the bubble burst. 

History of irrational exuberance

The question of what is irrational exuberance was first raised by a former chairman of the US Federal Reserve (Fed) board in Washington, Alan Greenspan. In his 1996 speech titled The Challenge of Central Banking in a Democratic Society Greenspan referred to Japanese markets when he posed a rhetorical question:

“But how do we know when irrational exuberance has unduly escalated asset values, which then subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

His speech and the use of such vocabulary provoked a strong reaction among investors, with Tokyo and Hong Kong stock markets closing 3%. The shock waves continued through Frankfurt, London and the US, where equities fell 4%, 4% and 2% respectively. Greenspan has never used the term ‘irrational exuberance’ again.

Example of irrational exuberance

Two classic examples of investor’s over-enthusiasm causing a stock market crash include the dotcom bubble burst of the late 1990s that caused internet stocks to crash and the subprime mortgage crisis of the late 2000s that resulted in real estate prices’ freefall.

In both instances, the psychological behaviour of buyers drove respective asset prices to such a high level that when the bubble burst and prices corrected, it caused a further stock market crash resulting in billions of dollars being wiped out in a matter of days.