Irrational exuberance in investing can crush your long-term gains and rational planning. Here’s what investors need to know so they don’t fall victim to the hype.

In moderation, investor confidence can be a good thing. It’s what moves investors to take healthy risks that pay off for their portfolios and the larger economy.

But when investors get overconfident, that turns into irrational exuberance, and it leads them to make bad investing decisions.

What is irrational exuberance, and how can you protect your portfolio from it? Here’s what investors should know.

Irrational Exuberance Investing Definition

In investing, irrational exuberance is when investor confidence drives asset prices higher than their fundamentals logically justify. This is more than just a marginal rise. It’s best understood as a kind of mania—investors are so confident that an asset will keep rising in value that they completely lose sight of the asset’s intrinsic value.

Basically, investors get so confident that they lose sight of what an asset is actually worth. This means that they’re buying into a bubble, and eventually, the larger market will catch up, and the bubble will burst.

The term was first coined in 1996 by Alan Greenspan, the former Chairman of the Federal Reserve (commonly known as the Fed), in a speech to the American Enterprise Institute titled “The Challenge of Central Banking in a Democratic Society”. In his speech, Greenspan said, “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

He was asking the assembled crowd how central bankers could tell when assets become overpriced. His response was investor complacency—low interest rates led to steady income, which made investors complacent, and they ignored the risk in pursuit of ever-higher returns on the belief that the good times would last forever.

At the time, the Fed didn’t concern itself with the stock market or real estate prices. But Greenspan noted that central bankers should get involved when they notice that speculative frenzy is driving toward a dangerous bubble (a cornerstone of the Fed’s policy today).

How Irrational Exuberance Happens

Irrational exuberance can be understood as mania, but it doesn’t happen in a vacuum. Remember, while we like to think of financial markets as rational, they’re the product of human decisions and attitudes, and try as we might, people aren’t rational.

Irrational exuberance happens when investors look at positive signals and egg each other on. As Greenspan argued, they become complacent in the expectation that good times will last, and in their rush for profits, they overlook deteriorating economic fundamentals and bid ever higher, creating a bubble.

This process can only occur in the later expansion phase of the business cycle. This is when the economy has been plowing ahead at full steam for a while and there aren’t many new opportunities for growth—but investors still try to outperform the market, searching high and low for every potential overlooked profit.

And because investors are desperate for more new growth, they sink money into whatever asset happens to be rising without inspecting possibly deteriorating returns or poor economic fundamentals. If they stuck to the fundamentals, they would reject bad investments and keep their cash, but because they’re desperate for more growth, they turn to any shiny asset that might present an opportunity.

After that, herd mentality kicks in, and investors follow each other towards any new and exciting asset. There may be valid signs that prices are growing, but once irrational exuberance takes over, growth takes on unnatural speed. And eventually, when the bubble bursts and prices return to normal levels, investors panic and sell en masse at any cost, driving an economic contraction.

Irrational Exuberance in Action

Sound familiar? We’ve seen this cycle in action many times before throughout history, and it always follows the same pattern.

The Dutch Tulip Bubble

One of the most famous market bubbles and crashes of all time is the Dutch tulip market bubble, or tulip mania. This occurred in Holland between the early to mid-1600s during the Dutch Golden Age.

The height of the bubble was between 1634 and 1637, when tulips went for 10,000 guilders, roughly the value of a mansion on the Amsterdam Grand Canal. The rarest bulbs traded for six times the average person’s salary.

At the time, tulips were a luxury item, providing a sense of exoticism because they didn’t look like any other native flower on the continent. Yet they were also notoriously fragile and difficult to grow. Local cultivators figured out that a tulip could grow from seed or from buds that grew on the mother bulb, and while it took seven to twelve years to grow a tulip from seed, a bulb could flower the very next year. This produced “broken bulbs,” a type of tulip with a multicolored pattern rather than the solid-color imported flowers.

This created growing demand for the rare broken bulb, and it became all the rage in Holland to own tulips. Then professional traders got in on the action, and people began buying tulips with leverage, hoping to pay off their debts once they sold the bulbs for a profit.

Then confidence crumbled, and the market collapsed, sending prices crashing back down to earth and leaving investors unable to sell bulbs for even a fourth of what they paid. It wasn’t devastating for the economy, but it did undermine social expectations, namely the previous trust in other people’s ability to pay.

If this sounds like a familiar cycle, that’s because we’ve seen this pattern in recent history: the Great Depression, the Dotcom Bubble, and the U.S. housing bubble, just to name a few.

Avoiding Irrational Exuberance as an Investor

As an investor, irrational exuberance can spell disaster for your portfolio. And you can’t let yourself fall victim to the pull if you want to protect your long-term gains.

While it may be tempting to ignore warning signs, you should always watch economic indicators. Even if an asset seems to have meteoric growth, if the price doesn’t match the underlying value, it will eventually crash. And if the indicators say the market isn’t as strong as it looks, you shouldn’t let yourself slip into a herd mentality and place your money on a sinking ship.

Invest Smartly This Year

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