A Crisis of Beliefs: Investor Psychology and Financial Fragility.

• Author: Zuluaga, Diego
• Position: Book review

A Crisis of Beliefs: Investor Psychology and Financial Fragility

Nicola Gennaioli and Andrei Shleifer

Princeton, N.J.: Princeton University Press, 2018, 264 pp.

Investment fund pioneer Sir John Templeton wrote that "bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria." There is a long line of economists and financial historians who have studied investor propensity to sudden mood swings. Charles Kindleberger wrote a celebrated history of financial panics that remains a reference four decades after publication. Hyman Minsky pointed to the recurrence of abrupt reversals at the peak of speculative manias, prompting a plunge that resembles Wile E. Coyote's when he realizes there is no ground under him. Robert Shiller won a Nobel Prize for documenting excess volatility in stock prices that fundamental factors cannot explain.

Identifying periodic bouts of irrationality in security markets is thus not an academic innovation. But so far, researchers have struggled to sketch out the policy implications, for both private investors and public authorities, of their findings. Can "irrational exuberance," as Federal Reserve chairman Alan Greenspan characterized the market's mood in the mid-1990s, be diagnosed, quantified, and acted upon?

A Crisis of Beliefs, by Bocconi University's Nicola Gennaioli and Harvard's Andrei Shleifer, has the reader pining for an affirmative answer, only to have his hopes ultimately dashed.

The book is mainly a summary of the authors' research with Pedro Bordalo at the University of Oxford. At its heart is the concept of diagnostic expectations, which are neither rational in die sense of incorporating all available information, nor merely extrapolative of past experience. Rather, diagnostic expectations respond excessively to news, leading to a distorted estimation of the likelihood of future outcomes. In this way, investors become unduly enthusiastic in good times and overly gloomy in bad.

To justify their hypothesis, Gennaioli and Shleifer draw on the cognitive biases established by behavioral economists. The notion of "representativeness"--when subjects systematically overestimate the probability of unlikely events that are made more probable by recent information--features prominently in their models. New information can make certain outcomes more likely, but people tend to overestimate how much more likely. For example, rapid house price growth in the run-up to 2007 led market...