Shiller’s Research Discredited Fama’s Research

Does timing work? When it comes to long-term timing the answer is maybe

Sometimes it is helpful to get back to basics.

Q2 hedge fund letters, conference, scoops etc

Robert Shiller’s Nobel-prize-winning research discredited Eugene Fama’s Nobel-prize-winning research.

I don’t mean that as any kind of dig at Fama. I believe that Fama’s research showing that short-term timing doesn’t work was of huge importance. I believe that Fama entirely merited his Nobel prize.

But I don’t believe that Fama's research shows that long-term timing (price discipline) is not required for investors who hope to keep their risk profile roughly constant over time. Fama did not even examine long-term timing, so he could not possibly have demonstrated such a thing. Until Shiller showed that long-term timing always works, researchers did not distinguish between the two types of timing. So, when Fama showed that one type of timing does not work, it was assumed that the other type of timing did not work either. Shiller discredited that assumption.

It is by combining Fama’s finding that short-term timing doesn’t work with Shiller’s findings that long-term timing does work that we are able to make full sense of the stock investing project. To say that what Shiller did was important is not to take anything away from Fama, who also did something important. But we do need to correct the misimpression that was created in the years between the publication of Fama’s research showing that short-term timing doesn’t work and the publication of Shiller's research showing that long-term timing does work. In those years it became a widespread belief that no form of market timing works. And there is simply no research-based support for that belief.

It seems strange to me that I even feel required to write these words. Both Fama and Shiller were awarded a Nobel prize in Economics in 2013. The New York Times article reporting on the awards noted that it was odd that two economists with opposing ideas on how the stock market works were both being given the highest honor in their field at the same time. One of them has to be wrong. Is it proper to give an economist who got an important economic question wrong the highest honor in his field?

In ordinary circumstances, that article would have launched a national debate on the matter. Who is right, Fama or Shiller? We all should have been talking about that in 2013. Actually, we all should have been talking about it in 1981, when Shiller published his “revolutionary” (his word) findings. We didn’t have that national debate in 1981 and we didn’t have that national debate in 2013 and we still haven’t had that national debate as of this date in 2018. I see that as a highly unfortunate reality.

No research can get everything right. No researcher can see into the future. No researcher can make use of research that will not be published until subsequent years to inform his own research efforts.

Fama did nothing wrong. He made an important contribution. Everyone should recognize that. But everyone should also recognize that Shiller too made an important contribution. And that it is impossible to give Shiller credit for his important contribution without acknowledging that a finding that was attributed to Fama but that was not really supported by his research -- that long-term timing as well as short-term timing does not work -- was discredited by Shiller's research. If valuations affect long-term returns, the risk of stock investing is not static but variable. If stock investing risk is variable, investors who want to maintain a constant risk profile over time are required to practice long-term timing.

I believe that the reason why these matters have not been resolved for so many years is that they are highly delicate. Stock investing matters. If investment advisors get investing questions wrong, they will hurt millions of people in very serious ways. So we all appreciate how important it is to get this stuff right. And we all are reluctant to say that any leading researcher got an important question wrong. So we pull back from saying such a thing even when it is demonstrated by the findings of subsequently published research.

We don’t help our investment researcher friends when we do that. Our investment research friends want to get it right. When they get something wrong, they want to fix their mistakes. To fix their mistakes, they first need to become aware of them. It’s not always easy to become aware of one’s own mistakes. We all suffer from cognitive dissonance from time to time. We come to believe certain things and then we come to build models based on those fundamental beliefs and then we become reluctant to question those core assumptions when surprising evidence appears before us that they are in error. It is the job of the entire society -- each of us plays a role in pushing things in a positive direction -- to alter the path by which knowledge travels as new ideas enter the public sphere.

Eugene Fama is a hero of mine. So is Robert Shiller. I don’t believe that Shiller could have done his amazing work had Fama not come before him and laid the foundation on which Shiller's research rests. But I don’t believe that we should still be saying in the year 2018 that timing doesn’t work. We should be saying that short-term timing doesn’t work. Fama really did show that and his finding has stood the test of time. But we should not be saying that long-term timing does not work. Shiller showed that it does.

Shiller discredited the claim that is often said to follow from Fama’s research that no form of market timing works or is required. We should all acknowledge that or at the very bare minimum acknowledge that there are two schools of academic thought re these matters and that they are by no means settled.

Rob’s bio is here.