ABSTRACT
This chapter seeks to explain why deviations from ‘traditional’ valuation methods and investment strategies employed in the 1990s generated an unsustainable rise in US stock prices-above and beyond justified by pure fundamentals. As discussed in Chapter 1, there were broad macroeconomic and geopolitical forces at work. At the corporate level, there were several biases that overstretched valuations. Stock markets are notoriously ‘noisy’ and prone to wild fluctuations, as they concern themselves with future asset prices and income flows. Given such uncertainty about the future, there is much room for oscillation between investor optimism and pessimism. Even though asset prices are driven by economic and financial fundamentals in the long run, they do deviate from such equilibrium values in the short run. History teaches us that what often starts out as being a ‘real boom’ transforms itself into a ‘financial bubble’. Overtrading, speculation, trend chasing, changes in risk perception, crowd psychology and an over-dependence on borrowed money generate volatility in stock prices. Given the bias of many investors for short-run capital gain, rather dividend flow, there is a high degree of sensitivity to ‘news’ and more importantly the interpretation of that news. Hence, US stock prices moved in line with changes in investor sentiment and perceptions of risk-a crowd psychology-that not to play was to miss out. Besides, there was money to be made irrespective of whether stock prices reflected fundamentals or not. This chapter examines the rationality debate-why it was rational for the individual to speculate in the short run but not collectively rational in the long run. It is also important to examine behavioural biases along with changing incentive structures.
