Shiller Shows Too Much Respect for the Efficient Market Hypothesis


Valuation-Informed Indexing #107

by Rob Bennett

It’s the Efficient Market Hypothesis that has caused all the trouble. If the market price reflects all known information, it’s essentially “right.” If the market price is equally right at all times, Buy-and-Hold is the way to go. If the market is efficient, Valuation-Informed Indexing strategies make no sense.

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Yale University Economics Professor Robert Shiller is the grandfather of Valuation-Informed Indexing. So Shiller obviously does not believe in the Efficient Market Hypothesis. His entire book Irrational Exuberance shoots holes in the idea that market does a good job of assessing the true value of stocks. But there’s a line in the book that cuts the other way that has always troubled me.

Shiller says: “The efficient markets theory and the random walk hypothesis have been subjected to many tests using data on stock markets, in studies published in scholarly journals of finance and economics. Although the theory has been statistically rejected many times in these publications, by some interpretations it may nevertheless be described as approximately true. The literature on the evidence for this theory is well developed and includes work of the highest quality. Therefore, whether or not we ultimately agree with it, we must at least take the efficient markets theory seriously.”


I don’t buy it.

The Efficient Market Hypothesis is a silly idea. The idea that the market sets prices properly has caused more human misery than any other idea ever advanced in the history of personal finance. As Shiller’s words above note, the theory has been statistically rejected many times. A theory that has been statistically rejected many times is NOT a serious theory. It is a foolish, dangerous, wrong-headed theory. Why does Shiller conclude otherwise?

He says that the word done in support of the Efficient Market Hypothesis is “of the highest quality.” What does that mean? My sense is that Shiller and I have very different ideas of what the phrase “of the highest quality” signifies.

It is a question that has come up many times in my 10-year effort to get the errors in the Old School safe-withdrawal-rate (SWR) studies corrected. Those studies get the numbers that millions of people have used to plan their retirements wildly wrong because they do not include adjustments for the valuation level that applies on the day the retirements begin (because the authors of the studies believe in the Efficient Market Hypothesis!). When I report that those studies get the numbers wildly wrong, the response of the authors of the studies if usually to ask me to identify a numerical calculation that is in error.

There are no numerical calculations that are in error in the Old School SWR studies. I am confident that there are no numerical calculations that are in error in the studies supporting the Efficient Market Hypothesis.

I am not impressed by that fact. I do not think Shiller should be impressed either. I do not think you should be impressed either.

Getting the numerical calculations done properly is the easy part of any research project. The part that is hard, and the part that is most important, is getting the logic right. Do the findings of the study make sense? Are the findings consistent with other things we know to be true about stock investing? If not, the study is not of “high quality,” in my assessment. Studies in which the numerical calculations are performed properly but in which logic and clear thinking are lacking are dangerous. 

It is those sorts of studies that possess the greatest potential to mislead. The error in a study that gets the numerical calculations wrong can be easily identified and easily fixed. So those sorts of errors don’t do much harm. But it takes some work to identify the error in a study that is rooted in faulty logic. And my ten years of experience trying to get the Old School SWR studies corrected shows that getting those sorts of studies fixed can be a most difficult undertaking.

We should not be praising studies with weak logic and strong calculations. We should be warning people of the dangers of placing their confidence in such studies.

Shiller hints at the reason why the logic behind the EMH studies went haywire. He says: “The efficient markets theory asserts that all financial prices accurately reflect all public information, at all times. In other words, financial assets are always priced correctly, given what is publicly known, at all times. Price may appear to be too high or too low at times, but, according to the efficient market theory, this appearance must be an illusion. Stock prices, by this theory, approximately describe ‘random walks’ through time; the price changes are unpredictable since they occur only in response to genuinely new information, which by the very fact that it is new is unpredictable.”

Do do you see the logic flaw?

I don’t say that it is easy to see it. It took me years of study for it to become clear to me. But I don’t think it takes a genius to see it. I think that the sort of people who publish high quality investing research should have been able to have figured this one out in the three decades since Shiller’s research showed that the story told by those backing the Efficient Market Hypothesis does not add up.

Stock prices are random in the short term. That has indeed been shown.

Does that finding necessarily lead to a conclusion that stock prices are determined by “genuinely new information”? It does not.

There’s an alternative explanation.

It could be that stock prices are determined by investors’ emotional impulses. Emotional impulses are irrational phenomena. They are unpredictable. A showing that stock prices are random is 100 percent consistent with a belief that stock price changes are determined primarily by investor emotion.

That’s the opposite of what the Efficient Market Hypothesis posits. If prices are set by investor emotion, they are almost always wrong, not almost always right. If you jump to the conclusion that the randomness of prices means that prices are always right, you can cause an awful lot of financial misery for an awful lot of people.

It’s not my intent to mock the people who came up with the Efficient Market Hypothesis. The hypothesis was an intellectual advance. The people who came up with the concept were smart and hard-working and good people. I admire them and respect them.

That said, I think we need to stop showing them so much deference. They made a mistake. Their work was not of the highest quality. It was flawed work. They could have done better. The calculations were done plausibly and the logic chain employed was plausible. But more thought should have been put into this before the level of dogmatism we have seen from the Buy-and-Holders in recent years evidenced itself.

The research that supports the Efficient Market Hypothsis was acceptable research. It was not research of the highest quality. It was gravely flawed work.

We need to take the Efficient Market Hypothesis seriously because it has caused so much harm. We need to stop being s deferential towards the people who made the mistake. We hurt them by showing a deference that encourages them to continue in their prideful refusal to acknowledge the mess-up.

Rob Bennett favors watching pennies but not pinching pennies. His bio is here.


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