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Irrational exuberance was coined by Federal Reserve Chairman Alan Greenspan in December 1996 to describe the behavior of investors. The S&P 500 and Nasdaq indices have since enjoyed the greatest run-up in their history-prompting widespread belief that something other than company fundamentals is driving stock prices higher.
The field of behavioral finance has gained widespread notoriety during the past decade, in part because it seems to explain such unusual market behavior. Some of the latest research conducted by Yale professor Robert Shiner, examines the recent market developments and tries to put them in historical perspective. His book, aptly titled Irrational Exuberance, foretells of a substantial correction in the market that could happen at any time. And several financial planners have taken it as a signal, as well as a tool, to better prepare their clients for the possibility that a downcycle is imminent.
"People see the market now- as fruit on a tree," said Lew Altfest, Ph.D., CFP, president of L.J. Altfest and Co., a financial advisory firm in New York. "Only they don't believe that the fruit can be sour. And they climb the ladder to pick it; they never think they can fall down.
"You have to give your clients constant education," Altfest continued. "I think there is a 50 percent chance that the market is going to decline (substantially) in the near future, and you have to prepare them for that possibility."
Managing Client Expectations
Managing client expectations has always been one of the most difficult challenges for financial planners. It has become even more difficult as of late. Long-term investing now seems to be measured in months instead of years. Market timing is in vogue. As Professor Shiner writes, investor expectations are out of whack. If he is correct in his prediction of a market downturn, that challenge of managing expectations is going to become greater still. Planners who can't perfect this skill will likely perish. Those who can will survive and likely emerge from the correction, strengthened in their numbers of clients and the more realistic return expectations of those clients.
In Irrational Exuberance, Professor Shiner demonstrates that there have been three dramatic market run-ups before this one. All have ended with sustained market corrections of at least 56 percent...