The Stock Market Seems Safer If We Presume Rational Investors

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Stock investing is scary.

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I believe that that is the core reason why there has been so little examination of the far-reaching implications of Robert Shiller’s Nobel-prize-winning research in the 39 years since it was published.

What Causes Price Changes In A Rational Market?

In the pre-Shiller years, the thought was that the market is efficient. That’s another way of saying that the market is rational. In a rational market, price changes are caused by economic developments and the numbers on your portfolio statement report accurately the lasting value of your life savings.

This is where the Buy-and-Hold idea that market timing might not work or might not be required comes from. If the market is rational, you can count on the value that the market has assigned to stocks as being at least close to accurate. To time the market successfully, you would have to know more than the market as a whole as to where prices are headed. That doesn’t seem likely in the event that the market is rational.

Shiller’s research showed that the market is NOT rational, that prices were set by those highly emotional humans, who sometimes greatly overpriced it and on other occasions greatly underpriced it. I see great potential in Shiller’s research to enhance all of our lives because, once there is widespread acceptance that the market is not rational and that the numbers on our portfolio statement often do not reflect the economic realities at all well, we can all get about the business of making the market more rational than it is today. If we all faithfully practiced market timing, prices could never reach the levels where they reside today. Market prices become self-regulating in a world in which most investors understand the how-to implications of the last 39 years of peer-reviewed research in this field.

The Journey Is Scary

The end point of that journey would be a very bright and exciting place. But the journey itself is a scary one. So many of us are reluctant to step onto the new path.

Freud’s insights were scary. He told us that we cannot count on our minds to keep us clear as to our motives for our own actions. We are to a large extent controlled by things that happened to us many years ago, by ways of perceiving and reacting that are irrational and self-destructive. Hence, there was a great deal of resistance offered to Freud’s insights when they surfaced. Today, the value of psychological insight is widely accepted. But it took some time for his revolutionary ideas to become integrated into the average person’s understanding of how life works.

We are still in the resistance-to-scary-new-ideas stage when it comes to Shiler’s claim that much of the reported value of our stock holdings is the product of irrational exuberance rather than of solid economic realities. We don’t want to hear it. We want to believe in those portfolio numbers. To do otherwise is — scary.

We want to believe that the portfolio numbers are real. We want to believe that our retirement planning efforts are on track. We want to believe that the experts in this field know the real story and are telling it. We want to believe that our economic system is operating smoothly and has not been set up for a collapse when stock prices return to fair-value levels. We want to believe that we humans are on top of things.

How Stock Investing Works

From one way of looking at things, we are. We know more about how stock investing works in the real world today than we did in any earlier era of investing. Our understanding of the subject has advanced with time.

But from another way of looking at things, there has been no advance. What has Shiller achieved? We saw the CAPE number go to the most out-of-control value in its history in 2000. And it has remained at absurdly high price levels for most of the 20 years since. Shiller’s research is amazing. But it has not left much of a mark on the population of investors. Most investors have elected to ignore Shiller’s findings.

Because they are scared. The fear is that we humans do not have it as together as we like to tell ourselves we have it. To call our stock gains “irrational exuberance” is to insult us. If we were as smart and clear-thinking as we like to think we are, there would be no irrational exuberance. Shiller has insulted us! So we tune him out.

But I believe that his ideas will catch on with a larger number of investors in days to come. We all want to get this stock investing thing right. To do that, we need to humble ourselves enough to make a U-turn and go back and check how we came up with the idea that the market is efficient and rational and that our stock portfolio numbers reflect reality. That act of humility will permit us to take great strides. I believe that it is coming in the not-too-distant future.

Rob’s bio is here.