Valuation-Informed Indexing $367 on the topic of how and why Stock investing Works and the role of Robert Shiller

By Rob Bennett

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Sometimes when I am ready to leave for an appointment five minutes before I need to leave, I will pull Irrational Exuberance off the bookshelf and turn to a random page and see what I find there. I did that the other day and these are the words that jumped out at me off of Page 254: “The U.S. stock market ups and downs over the last century have made virtually no sense ex post. It is curious how little known this simple fact is.”

Um -- Okay. What do we do with that?

The fellow who wrote this book was awarded a Nobel prize. He must know something about the subject matter to which he addresses himself in his research. Yet here he is saying that changes in stock market prices cannot be explained with reason and logic. They happen. Prices go up, prices go down. But they make no sense. We cannot explain them. That’s what the man is saying.

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This goes against the grain. Changes in stock market prices affect our lives in a big way. Price increases permit us to retire sooner. They permit us to help our daughters and sons to attend college. They permit us to go on longer and more exotic vacations. They permit us to make biggest contributions to our favorite charities. And price drops of course do just the opposite. Price increases enhance our lives and price drops diminish them and so of course we want to understand them, we want to know where those price increases and price drops are coming from, we want to know what we need to do to enjoy more of the price increases and to endure fewer of the price drops.

That’s the project. That’s the investing advice project. Pretty much all of the human energy that is directed to understanding how stock investing works is in an ultimate sense being directed to understanding why stock prices go up or down and how to profit from it. Shiller is questioning that project. He is questioning everything. That’s why I say that we are today living through the Shiller Revolution in humankind’s understanding of how stock investing works.

Shiller is not a nihilist. He is not tearing down and failing to put something in place of the things he tore down. He is not saying that we should give up trying to make sense of price changes. The reality, of course, is that Shiller has done more to help us make sense of price changes than anyone who came before him. Those who believe in the power of Shiller’s P/E10 valuation metric can identify a range of possible returns for the stock market that will apply 10 years or 15 years or 20 years in the future and can assign rough probabilities to various points on the spectrums of possibilities. It was not possible to do that before. It is possible to do that today because of what Shiller discovered through his Nobel-prize-winning research.

We couldn’t predict stock returns if the process by which price changes are determined did not make sense. So Shiller is not saying that we cannot make sense of price changes. He is saying something more targeted: He is saying that we cannot make sense of price changes ex post.

Ex post means “based on knowledge and retrospection and being essentially objective and factual” or based on actual results rather than forecasts” or “based on analysis of past performance (opposed to ex ante)”, according to three definitions I pulled off the internet. Price changes can be explained. They just cannot be explained by the means through which we would intuitively expect to be able to explain them. There’s some wild, irrational element missing in the means by which we humans have long attempted to make sense of stock price changes.

The rest of Shiller’s book makes clear that that long-missing, wild, irrational element is human emotion. Throughout the history of investing analysis, we have tried to make sense of price changes through the use of logic and reason. Since stocks are bought and sold by people, not robots, the purely rational and logical approach does not compute. Humans are emotional creatures. To make proper sense of stock investing, we have to take into consideration how the human animal reacts to price changes as a result of the changes both positive and negative that they bring to his life, not just the ways in which he would react if he were a purely logical creature calculating how best to gain an advantage over his fellow humans.

Stock price changes don’t make sense according to the old way of thinking about them. They do make sense according to the model in the process of being created by advocates of behavioral finance. We cannot assume away irrationality in a world in which stocks are bought and sold by deeply irrational (but also sometimes rational) creatures.

That’s the Shiller revolution. That’s the idea.

Since investing analysis is largely a numbers game, this new way of looking at things changes everything. If stock investing were a purely rational endeavor, price changes would be determined by unforeseen economic developments and would play out in the form of a random walk. If stock investing is an activity engaged in by humans, price changes should be determined largely by shifts in investor emotion that should play out in a highly predictable long-term hill-and-valley pattern that investors can identify to dramatically reduce the risk of investing in this high-return asset class.

The most exciting thing about the Shiller revolution in our understanding of how stock investing works is that it puts us on a path to reining in the emotions that have made stocks such a risky investment class in the past. So long as we remained unaware of the wild, irrational factor driving price changes, we could do nothing about it -- investor emotion caused price crashes in the way that changes in weather conditions cause hurricanes that bring great misery to millions. We are now entering a time when we will be able to see in advance when the stock-crash hurricanes are on their way and move investors who in a more ignorant era would have suffered great misery to safe places.

To get there, we just need to give up our comfortable belief that we already know it all, that the conventional understanding of why stock prices rise and fall does an adequate job of explaining the historical realities.

Rob’s bio is here.