Robert Shiller did something important in 1981 when he published peer-reviewed research showing that valuations affect long-term returns. There’s a sense in which as a society we have recognized his achievement. Shiller’s book was a best-seller. He is interviewed frequently. He was awarded a Nobel prize.
But in a practical sense we have hardly acknowledged Shiller’s achievement at all. He showed that valuations matter. But how many investors take valuations into consideration when setting their stock allocations? Few do. We still act as if the market is at least largely efficient, as if Buy-and-Hold strategies are just fine. It doesn’t follow. If valuations matter, we should always be taking valuations into consideration. And we don’t. Shiller showed us something important and we just continued doing what we had been doing all along, as if the realities he revealed were of no consequence.
I am always trying to come to a better understanding of why this is so. I believe that is is because the reality that Shiller revealed is a deeply counter-intuitive one. What he showed is that it is investor psychology that determines stock prices, not economic realities. If it were economic realities that determined stock prices, they would play out in the form of a random walk (since there is no reason why economic developments would play out in predictable patterns). Shiller showed that valuation levels play out in a hill-and-valley pattern that has been repeating for as far back as we have records of stock prices. A random walk applies only in the short term, never in the long term.
What we have a hard time coming to grips with is the cause of the hill-and-valley pattern. It’s almost as if the market has a memory. How does it know to continue going up for many years until it reaches an unsustainable high and then to go sharply down and then after some time to repeat that pattern? What causes stock prices to play out this way over and over again? What mechanism makes it happen?
The mechanism is human psychology. We all have a Get Rich Quick urge residing within us. So we all want stock prices to rise as high as possible as quickly as possible. But we all also possess common sense. So we get uncomfortable seeing prices rise too high too quickly. There is a tug of war between the Get Rich Quick urge and our common-sense reservations over letting it get too out of hand that causes valuations to rise only gradually upward until they get completely out of hand and then to come crashing down hard when our common sense gains the upper hand over our Get Rich Quick urge.
The hard part to accept is that today's stock price is not real, that it represents only a passing emotional state-of-mind and does not reflect a lasting economic reality. I loved the reaction that I once got from a Buy-and-Holder when I made this point in a discussion thread at my blog. He asked me if I thought that the mutual fund in which he was invested would honor the price assigned to his portfolio if he tried to cash it in. The answer of course is that the mutual fund would honor the listed price. The owners of mutual funds are serious people. It is hard to imagine that they would be willing to put hard dollars on the table in response to a piece of paper reflecting only passing emotional realities. But they do! If Shiller is right that most of the gains that stock owners hold in their possession at times when valuations stand where they do today are the product of irrational exuberance, there are a lot of hard-nosed business people who are willing to treat irrational exuberance as something important and real.
There’s a deep irony in play here. If we took Shiller’s research more seriously, we would take the numbers on our portfolio statements less seriously. That would cause us to place less value on our stock holdings at times like today and to be willing to give up those holdings for a smaller number of dollars. If we did that, stock prices would drop and the numbers on the portfolio statements would do a better job of reflecting the economic realities than they do today. The market is not efficient automatically, as the Buy-and-Holders believe. But there’s every reason to believe that a stronger appreciation of the far-reaching implications of Shiller’s work would render it something close to efficient, that we have reached a level of understanding of how stock investing works at which market efficiency is a realistic possibility once we are able to overcome our lingering belief in the pre-1981 way of thinking about these matters.
Today's stock price does not reflect the economic realities. It’s a scary thought. It means that we don’t have as much in our retirement accounts as we have been led to believe. That’s not good.
The deeper reality is a highly positive one, however. If Shiller is right, we have been fooling ourselves all these years by putting too much credence in the numbers on the portfolio statement. Financial planning is a numbers-based exercise. If we have been using bad numbers, we obviously have not been doing a good job of financial planning. By pointing out the mistake, Shiller has showed us all how to do a better job of financial planning and thereby how to live fuller and richer lives.
Today's stock price does not reflect the economic realities. It’s hard to accept that. We are 37 years down the road and Shiller’s “revolutionary” (his word) research findings have thus far had only a minimal practical impact. But the potential impact is huge. When we reach a place where we can accept the implications of what Shiller showed us, we will all live better lives from that point forward. I think that we are working our way through a difficult process of acknowledgment of the fundamental realities of how stock investing works and that we are close to achieving some very exciting advances.
Rob’s bio is here.