An Alternative to Fama’s Explanation of Short-Term Price Changes That Also Fits Shiller’s Finding of Long-Term Return Predictability


Valuation-Informed Indexing #169

by Rob Bennett

If stock returns appeared in the pattern of a random walk, Buy-and-Hold would work.

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They don’t.

Stock returns appear in the pattern of a random walk in the short term. It is because this is so that lots of smart people have concluded that Buy-and-Hold strategies make sense.

Even the most confirmed Buy-and-Holders acknowledge today that in the long run there is a strong correlation between the P/E10 levels that appear on one day and the returns that appears 10 and 15 and 20 years later. So stock returns are NOT a random walk.

The thinking, however, is that they ALMOST appear in the form of a random walk. Thus, the logic goes, Buy-and-Hold should kind of, sort of work. The reality is CLOSE ENOUGH to what it would need to be for Buy-and-Hold to work that Buy-and-Hold should produce results that are not so terrible.


There is a big difference between an investment strategy that almost works and an investment strategy that actually works. Buy-and-Hold may come close to working in theory. However, the flaw in the theory that prevents Buy-and-Hold from working in the real world does not cause it to produce slightly sub-optimal results. It prevents it from producing even barely acceptable result in the vast majority of cases.

Buy-and-Hold is slightly flawed in theory and horribly, horribly flawed in practice. Those drawn to this strategy (they number in the millions!) need to understand why.

Instead of focusing on the reality that stock returns fall out ALMOST as they should under Buy-and-Hold theory (returns are random in the short term but not in the long run), investors and analysts need to focus on WHY it is that returns do not fall out as they should under the theory. That is, why is is that the randomness of market returns DISAPPEARS after the passage of about 10 years?

This is an exceedingly counter-intuitive phenomenon.

It would be easier to understand if the reality were the other way around. If returns were not random in the short term but then became random in the long term, it might be possible to explain things by saying that there are some quirky factors sending results in strange direction for a few years but that the general impulse of the market to produce random returns in time accumulates enough strength to overcome the short-term peculiarities and to thereby to produce proper (in tune with the theory) results.

But how could it happen the other way?

If stock market returns naturally play out randomly, how could it be that they would play out randomly in the short term and then become predictable in the long term? Every long-term time-period is comprised of a number of short-term time-periods. How can a series of short-term time-periods that each produce random results join together to produce a long-term time-period that shows returns that are predicable by making reference to the starting-point valuation level?

We need to come to understand this mystery to understand how stock investing really works.

I’ll tell you what I think is going on.

Stock returns are random in the short term for a very different reason than the one that University of Chicago Economics Professor Eugene Fama has advanced. Fama says that short-term returns are random because all knowledge about stocks is immediately incorporated into the stock price. Thus, only new information affects prices. Since new information is just as likely to be bad as good, the incorporation of new information into prices has a random effect on those prices.

There’s a second explanation for short-term randomness that explains the short-term realities every bit as well and the long-term realities much better. It’s not only efficiency (which is just a different word for “rationality”) that can explain short-term randomness. A high degree of irrationality would also explain short-term randomness.

A perfectly rational market would indeed produce short-term randomness. But so would a perfectly irrational market. It is impossible to predict returns that are produced by unforeseen economic and political developments. But it is also impossible to predict returns that are produced by crazy shifts in investor emotions. Fama’s finding that short-term price changes are random supports the idea that the market is highly emotional every bit as much as it supports the idea that the market is highly efficient.

The difference between the two explanations is that Fama’s explanation for short-term randomness is discredited by Yale Economics Professor Shiller’s finding that long-term returns are highly predictable while the explanation that I am putting forward here is consistent with Shiller’s finding. Say that the market is highly emotional in the short term and that is why prices are random in the short term. Could prices be predictable (non-random) in the long term? They could. It could be that there is a second influence on prices that has little or zero effect in the short term but that comes to play a significant role in the long run.

i believe that investors are influenced both by emotions and by economic realities. They generally ignore the economic realities in the short term. But it takes more and more effort as time goes on for investors to push the common-sense realities out of mind. Eventually (it often takes 10 years or so for this to happen), the realities assert themselves. That’s when we see price crashes pulling stock prices back to where they would have been all along had investors made more of an effort to rein in their emotions.

Stock crashes cause economic crises. They are the poorest possible way for rationality to reassert itself. There must be a better way!

The better way is for experts to warn investors of the downside (lower returns) of high prices on a daily basis. Investors would not be able to act so irrationally if their advisors were regularly highlighting the dangers of ignoring price. If we all talked regularly about the implications of Shiller’s revolutionary findings, never again would we see prices get out of hand. Which means that never again would we see price crashes and the economic crises that inevitably follow from them.

Rob Bennett has recorded a podcast titled When Stock Prices Fall, Where Does the Money Go? His bio is here. 


Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”
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