Economists overvalue stock markets

October 31, 2013

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.


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“Top managers spend too much time watching the stock market.”

In the so-called market for corporate control, it the market value of a publicly traded company drops low enough, there is a substantial risk that the corporation will be taken over by outsiders willing to pay a “control premium” of 30% or so in a tender offer or other takeover bid. Shareholders are typically willing to sell at a 30% premium, so the result is that the managers lose their jobs. Thus, they watch the stock market to try to keep that from happening.

Posted by Bob9999 | Report as abusive

The article fails to distinguish between stock market investment and stock market trading, i.e. speculation. He is correct that stock market trading has little direct effect on the companies whose stock is traded. He is also correct that tying compensation of management to short term stock trading causes a significant, negative indirect effect. Management compensation should tied to the long term. Management should not be tied to the trading aspect of the stock market but to the investment aspect. This requires instead of short term options that management be given restricted shares that collect dividends but cannot be sold until 10 or 20 years out. It also means eliminating the current CEO nonsense. We should have a separate President and Chairman of the Board, and a Board that represents investors’ interests and not one that merely serves as club for the CEO’s buddies.

Posted by QuietThinker | Report as abusive

The problem is that many of these companies who are large enough to issue stocks on exchanges is that they exploit workers and tax payers. The corporations who play these gambling games with peoples lives, countries and communities are inherently corrupted.

Posted by 2Borknot2B | Report as abusive

The only thing that makes individual stock-prices even remotely good indicators of individual companies’ values is every participant in the stock market doing the best they can to maximize their economic benefit. If the participants in the stock-market did not try to maximize their returns on their investments, at the expense of the other participants or otherwise, then stock prices and the stock market as a whole would be completely meaningless.

Posted by Sewblon | Report as abusive

Once again Mr. Hadas displays his customary perception and balance. Well done.


I hate to pop your socialist bubble, but businesses do NOT “exploit workers and tax payers”. They exist for the purpose of commerce, and profitable commerce is the very foundation of everyone’s “standard of living”.

Said “standard of living” has advanced more WORLDWIDE in the last fifty years than in all previous recorded history; a fact often unknown, ignored, or dismissed. When there are more workers competing to meet the needs of business, the price, or wage each can demand drops. When fewer, wages rise. Business has no control beyond their ability to make jobs simpler and easier such that more can do them at lesser rates.

Until globalization, the United States was a “protected market” of the relatively affluent. Within that “protected market” was an “elite worker corp” that got more for their labor. They are known as unions.

Unions artificially increase their wage rates by restricting the number of “union” workers available and by negotiating or lobbying for “sweetheart” contracts or legislation requiring payment of “union scale” labor such as the Davis-Bacon Act. The result is that the majority of Americans who do NOT belong to unions have to pay MORE through their taxes for infrastructure maintenance and improvements than is justified in a free market.

It is with considerable dismay that “we, the people” face an exploding unionized work force in our GOVERNMENTS at all levels, local, state and federal. Fortunately, more and more states are adopting “Right to Work” legislation.

For an equitable world economy the artificial barriers isolating the American consumer market had to fall. When they did, the standard of living elsewhere then rose. Yes, the “value” of American labor has dropped as the “value” of labor elsewhere has risen in the “free market”, just like connecting lakes with different water levels.

Those who advocate isolationism and unionization merely wish in vain for a return of unfair advantage inappropriate in a world of more equitable commerce. Get used to it.

Europe buys your argument, hook, line and sinker. And it is the strength and resilience of the American economy and dollar that has to bail them out again and again without end. When will they ever learn?

Posted by OneOfTheSheep | Report as abusive

Way to go Ed…total greed buzzkill. How am I supposed to get excited about my day-trading addiction now??

Posted by changeling | Report as abusive

Very well put @OOTS.
The “Race to the bottom” slowed the impact of automation, but it is starting to catch up. China is now automating many of its factories as labor costs are rising.
As far as Stock market thinking; I think the markets have a huge change coming. The banksters of the world have forced investors into it by not offering anything else to invest in. The vast majority of the working classes retirements are now there for the taking. The banksters have changed how trading and speculation are done with ruthless algorithms to siphon directly off the top. All of you investors should watch the TED Talk on how Algorithms shape our world. His talk is mainly about the stock market flash trading. It will shock you, and it is absolutely true. Even sponsored by the biggest banksters of them all, Goldman Sachs. w_algorithms_shape_our_world.html

Posted by tmc | Report as abusive

Unfortunately usually Mrs. Brown normally performs worse than Mrs. Smith. Active management with mutual fund fees, tax consequences, and advisory fees has shown time and time again to underperform by exactly the amount of such fees. Anybody interested in a sustainable solution should look towards a method of low cost indexing. If they are concerned about advice and planning, they should seek out an advisor who uses low cost indexing.

Posted by ArCaMa | Report as abusive

You say ‘The main economic influence of share price moves is indirect, and basically negative.’ Can you suggest an alternative to the public equity markets? They give companies access to a vast pool of capital, which is not otherwise available on comparable terms and without which many of those companies would not exist. The public equity markets have many flaws, but we would all be greatly poorer without them.

And to say that Mrs. Smith and Mrs. Brown contributed the same thing to the economy, ie their savings, and therefore deserved to receive roughly the same returns on their investment is equally curious. Should bank deposits generate the same return as shares in a start-up venture? If so why would anyone back the start-up venture? And where would we be then?

Edward Hadas’ reasoning seems like a justification for a Marxist economy. Or is he pulling our leg?

Posted by Fras29 | Report as abusive

I’m sorry, you’re just wrong: k-price-matters-regardless/

Posted by DavidMerkel | Report as abusive

@DavidMerkel, Mr. Hadas was speaking as an economist as he is one. His words also ring true to us layman. We were all taught or lead to believe that stocks prices were a reflection of a company, How well it was doing, how strong it was. Your article doesn’t mentation anything like that. In fact, your article explains your position as an investment professional. Of course stock prices mean everything to you. Mr. Hadas points out accurately “In contemporary society, the stock market is treated as something like a professional sport.” and you are a player. Since you are a player, please explain to us how the concept of flash trading algorithms ( the link I posted) play a part in stock pricing? You see, most of us believe them to be a distortion, a corruption. Banksters and financial professionals have so complicated the industry that they themselves can truly understand it. Complexity is added merely so the confusion can allow more of the investors money to become more of the bankster or professional money. So do stock prices really matter? No, they are just the current spread in your game.

Posted by tmc | Report as abusive