Correcting Irrational Exuberance

Abstract

Irrational Exuberance (Greenspan, 1996; Shiller, 2000, 2006) depicts that the volatility of stock market may result partly from investor psychology and as a result investors may bias financial judgments with affective and non-fundamental variables. Yet one lacks a theoretical framework and methodology to separate the affective bias (psychology) from the fundamental sensitivity (economics) in stock or fund judgments. The author proposes a signal detection theory (SDT) framework and the SDT methodology to separate the bias from the sensitivity based on modeling and computing the data of 11012 mutual funds. With this SDT approach, a seemly good fund with a high average return rate actually may not be a good choice for future investment because its fundamental sensitivity is weak. Hence, the irrational exuberance for the fund may be corrected with the fundamental sensitivity indicator. The searchable results on the sensitivity (dprime) and bias (bias_c) for these funds are available at the YesWici.com website. Based on the SDT model, YesWici.com also presents an online Monte Carlo Simulation (MCS) forecasting engine to calculate and compare future fund performance.