Economists overvalue stock markets
Is it possible to construct portfolios which perform better than the overall stock market? Two of the three recipients of the latest Nobel prize in economics have tried to answer that question. Roughly speaking, Eugene Fama said that all efforts are in vain, while Robert Shiller said that they are not.
These nearly contradictory views are typical of an intense but inconclusive argument stretching back four decades. Market researchers have produced a mountain of studies, but they rarely consider the macroeconomic, ethical and social meaning of equity investing. That’s a shame. If more attention were paid to these issues, everyone could calm down.
Start with the economics. For the economy as a whole, changes in individual stock prices are basically irrelevant. The companies receive no cash when existing shares trade hands, whatever the price. The trading shareholders may have gains and losses, but they cancel each other out. The net economic effect of frenetic stock markets is zero.
The share price does matter when new shares are issued, but that happens rarely. While promising young companies can use cash to expand, and troubled older ones need cash to survive, in normal times companies generate all the cash they can invest profitably from operations, so they don’t need or want to raise new capital. It’s perfectly reasonable that over the last seven years, the value of newly issued shares was only about 10 percent higher for listed U.S. companies than the value of repurchased old shares, according to data from Thomson Reuters Datastream and Factset.
The main economic influence of share price moves is indirect, and basically negative. Top managers spend too much time watching the stock market. They hope for bonuses which are often based on share prices and they fret about being taken over. Both concerns lead them to follow the advice of stock market investors, outsiders who rarely have much insight into long-term strategic issues. Although activist investors can occasionally clarify their thinking, managers would usually be well advised to ignore the market price and rely instead on their superior knowledge as insiders.
Then there is the ethical issue. It is hard to justify investors’ desire to outperform their peers. I think of it as the Smith-Brown paradox. The name comes from my time as an equity analyst, when one of my bosses tried to cheer us on by reminding us of a putative Mrs. Smith, who had entrusted her savings to us. If we outperformed, he explained, her retirement would be more comfortable. But I kept thinking about an equally putative Mrs. Brown, the neighbour who had entrusted her savings to a rival fund manager.
I sympathised with Mrs. Smith’s desire to pay for more trips to see her grandchildren, but I didn’t see why Mrs. Brown should be stuck at home. Neither of them had funded anything new or risky; they had both merely bought a collection of shares from other holders. They contributed the same thing to the economy – their savings. The ethical conclusion was clear: they deserved to receive roughly the same returns on their investment.
Luckily, Mrs. Smith and Mrs. Brown usually do. The results of the many studies into actual investor performance – the line of enquiry recognised by the Nobel prize – are comforting. There is not actually much to be greedy about in the relative performance game. For all reasonably large and diversified portfolios, the outperformance or underperformance relative to the entire market rarely averages to more than 1 or 2 percentage points a year.
So after subtracting the often substantial management fees, Mrs. Smith and Mrs. Brown generally do about equally well over time. The gap in their retirement incomes isn’t large enough for Mrs. Smith to feel very hard done by if she happens to have chosen the wrong fund manager.
Perhaps outperformance in investing could be more properly treated like its equivalent in sport. The phrase “playing the market” is instructive. In contemporary society, the stock market is treated as something like a professional sport. The fun of investing, for everyone from amateur day traders to highly-trained professionals, is in trying to win. And, like any other participatory sport, the market contest naturally has winners and losers. As at a Church bingo night, the excitement of the game might even help raise funds for good causes – in this case for investment.
I’m sure Fama and Shiller deserved their prizes. Shiller, in particular, has shown that the whole stock market can be overvalued – a helpful indicator of excess in the financial system. But far too much attention has been paid to the search for relative outperformance, which amounts to an economically pointless effort to gain an elusive and potentially unethical edge.