Valuation-Informed Indexing #338
by Rob Bennett
I recently discovered the video of Robert Shiller’s acceptance speech when he received his Nobel Prize in 2013. I was cheering when he made a point that I have advanced several times in this column but that I have never before heard any big name put forward. The point is simple enough that I did not doubt my own understanding of the surrounding issues. Still, it’s hard for me not to be a little concerned about a point that I am making when it is an important point with far-reaching implications that can seemingly be understood by just about anyone and yet people possessing a good deal more smarts than me don’t seem to appreciate it. So I felt relieved to hear a fellow make the point during his acceptance speech for the greatest honor one can receive in this field.
The latest Robinhood Investors Conference is in the books, and some hedge funds made an appearance at the conference. In a panel on hedge funds moderated by Maverick Capital's Lee Ainslie, Ricky Sandler of Eminence Capital, Gaurav Kapadia of XN and Glen Kacher of Light Street discussed their own hedge funds and various aspects of Read More
Shiller said (about 10 minutes into the video): “My attitude is — Why are we so interested in the efficient markets model? Because we haven’t seen any compelling evidence for it. It may be that we have trouble rejecting it. It depends on your model of human nature.”
There have been many articles and papers written arguing the case for and against the Efficient Market Theory. A good number of them employ sophisticated mathematical and analytical tools to support their arguments. In fact, I have been told by my critics that I lack both the economics background and the statistics background to be qualified even to question the expert opinion on this topic. And I have run into many middle-class investors whose lives will be greatly affected by whether it is Fama or Shiller who is right and who have staked their personal retirements on a belief that it must be Fama who is right given how sure the experts who argue for Buy-and-Hold strategies claim to be re their conclusions.
It has often seemed to me that there is not really any there there.
That’s what Shiller is saying in the words quoted above. Shiller of course possesses the economics and statistical expertise that I lack and he is able to make use of the same sophisticated analytical tools that the Fama adherents use when making his case for a very different way of understanding how stock investing works. But Shiller is making his case in a very simple way in the words above. He is not presenting any statistical evidence at all. He is asking the question posed by the small boy who noticed that the king wasn’t wearing any clothes.
Shiller is too nice a guy to say “isn’t this entire idea that the stock market is efficient a bunch of silliness?” which is how a nasty fellow like me would probably be inclined to state the thought. But the content of his words — “Why are we so interested in the efficient markets model? Because we haven’t seen any compelling evidence for it — suggests the same thought. It’ all a big bunch of hooey! It’s silliness. We can go on and and on with these studies and reports and articles and arguments and it is never going to settle anything because you can’t reason someone out of a position that they did not arrive at through the use of reason in the first place. People believe in the Efficient Market Theory (and in the Buy-and-Hold strategy that follows from a belief in it) because they want to believe in it, not because any case has ever been made justifying that belief.
That’s the most important reality of the entire debate. People believe in the Efficient Market Theory and in Buy-and-Hold. There is no cause to doubt the sincerity of the millions of smart people who believe. But the data and the analytical tools and the arguments advanced in support of this cluster of ideas all serve as distractions from the core point. The Efficient Market Theory is a matter of faith, Buy-and-Hold is a religion. People believe because they believe. They offer arguments and data to support the belief because they don’t think it sounds good to say that they believe because they believe. But that’s the reality. You will go mad trying to make use of reason and data to talk a Buy-and-Holder out of his belief.
It is not my intent to be insulting to my Buy-and-Hold friends. I was a proud Buy-and-Holder myself at one time. So, if I were to point a finger, the proper thing to do would be to point it back at myself. And of course Shiller does not intend to be insulting. He joked around about his differences with Fama several times during his talk, making clear that he feels respect for him and in fact believes that there is partial merit in the Efficient Market concept (as do I).
It’s strange. Very smart people believe strongly in an idea for which “there is no compelling evidence.” How did this strange turn of events come to pass? I have spent a good number of early morning hours (the part of the day in which I do my most creative thinking) pondering this one.
I believe it goes back to Adam Smith. Smith initiated the study of “economics” as we think of it today. He popularized the idea of assuming rationality in economic actors and then assessing the possibilities that follow from that assumption as a scientific endeavor. Because possibilities are assessed using scientific tools, we have come to think of economics as a kinda, sorta scientific endeavor. Economic papers look like scientific papers. In reality, however, they can never be that so long as the work done is rooted in the assumption with which Adam Smith kicked off the whole shebang — the assumption of rational human actors.
Humans are not rational actors. All novelists know this. All real estate salesmen know this. All marriage counselors know this. All smokers know this. Shiller’s wife is trained in psychology. It occurred to him one day that perhaps some of the ideas that drove her studies of the humans might apply in the investing context too since after all stocks are both bought and sold by those same humans. And of course it turned out that it is only by taking the irrational human part of the story revealed by the P/E10 metric into consideration that it is possible to come up with a model for understanding stock investing that actually corresponds with how things always play out in the real world.
Valuation-Informed indexing has met with a lot of skepticism because it is so big a change. Shiller didn’t just revolutionize our understanding of how stock investing works, the day will come when it will be seen that he revolutionized our thinking re how economics in general works. The economists have been getting it wrong for many years. We just didn’t know because their mistakes did not cause millions of us personal financial pain. When Fama incorporated Smith’s false assumption into his model for understanding how stock investing works, he made it possible for us all to see how off Smith’s assumption was all along.
Rob’s bio is here.