Were Shiller’s Research Findings a Surprise?

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Robert Shiller was awarded a Nobel prize in 2013. It was for his 1981 research showing that valuations affect long-term returns and thereby discrediting the Efficient Market Theory.
This was not expected. The Efficient Market Theory had achieved such widespread acceptance among academic economists that it served as the cornerstone for the Buy-and-Hold Model for understanding how stock investing works. It was because it was once widely believed that investors behave rationally when buying stocks and that prices thus react quickly to changes in economic realities that we are so often told that market timing is not required. If prices always properly reflect the economic realities, there is no need for market timing to take them back to their proper place.

The effects of Shiller’s research

In one sense, Shiller’s findings came as a shock. It is a rare event for the publication of research to cause its author to be awarded a Nobel prize. Shiller’s research is clearly regarded as being a very big deal. It overturned the understanding of how stock investing works that was dominant before it was published.

Yet his research has had close to zero practical effect.

Can you name one way in which today’s investors follow different strategies than they followed in pre-Shiller days? I cannot. There are a small number of investors (I put it at about 10 percent of the investing population) who engage in market timing when valuation levels rise very high because of concerns that irrational exuberance makes stocks more risky. The vast majority of investors do nothing different. Today’s CAPE value of 32 highlights the point. Such a CAPE value would be impossible if investors took Shiller’s finding that valuations affect long-term returns seriously (they would lower their stock allocation when prices got dangerously high and those sales would bring prices back to reasonable levels).

Shiller’s research changed everything and changed nothing at the same time. That’s quite a trick.

I’ve been writing about this strange reaction to Shiller’s research findings for 20 years now, trying to come to a full understanding of it. What I think is going on is that the advance in understanding is so big that we have not as a nation of people been able to process it. For valuations to affect long-term returns, there has to be some secret ingredient in valuations that makes them like no other factor that affects stock prices. Changes in all other factors are incorporated into the stock price quickly. They don’t affect long-term returns, they affect returns immediately. Valuations only have an effect in the long-term.

Why? Because to misprice stocks is to engage in self-deception. When stocks are mispriced, we are kidding ourselves about the real and lasting value of our holdings. We are engaging in Get Rich Quick thinking. We are trying to obtain something for nothing. That’s embarrassing. And it’s scary. When we deceive ourselves that way, we put our ability to plan for our financial future in jeopardy. How could we do such a thing? We’ve been doing it since the first stock market came into existence. But we don’t like to think about what we are doing when we do it. We don’t like to talk about it.

Shiller cast a light on our self-deceptive and self-destructive investing behavior – creating irrational exuberance out of thin air by telling ourselves all sorts of lies about why stock prices should be higher than what is justified by the economic realities. So the entire subject must be shrouded in secrecy. We turn a deaf ear to Shiller’s message. We recognize Shiller’s contribution. We buy his books and award him important prizes. But we go about the business of buying stocks as if his research did not exist.

We are not surprised by Shiller’s findings. If we were, we would talk about them all the time. We would explore all of their far-reaching how-to implications. Almost none of that goes on today. We don’t give enough recognition to Shiller’s findings to be surprised by them. Shiller’s research findings are a shameful reality not to be mentioned in polite company.

I think that Shiller’s findings are a wonderful surprise that should be embraced in gratitude by all of us. But there is so little discussion of them that I sometimes wonder if they really exist at all. Did I just imagine that valuations affect long-term returns? If stock investing research is awarded a Nobel prize and no one’s stock buying behavior is altered as a result, does it really exist in the same manner as all of the research papers that are not awarded a Nobel prize?

I believe that we will get there one day.

Rob’s bio is here.