Opinion

James Saft

Invest like Fama but regulate like Shiller

October 16, 2013

Oct 16 (Reuters) – If the board awarding this year’s Nobel
Prize in economics didn’t get bogged down in a foolish
consistency, there is no reason for you to.

The award this year went to Eugene Fama, Robert Shiller and
Lars Hansen, leading to much hand wringing over the apparent
conflicts between the work of Fama and Shiller. (Hansen is
mostly known for research on risk, which may be why so few are
discussing him.)

Fama is famous for the efficient markets hypothesis, which
posits that securities prices reflect all available information,
which on the face of it makes quite a contrast to Shiller’s
central assertion that animal spirits – greed and fear, to you
and me – drive financial markets and make bubbles a regular
feature.

First off, economics is a social science, not a hard
science, so don’t kid yourself that anyone has the final word on
anything. You may as well go to the opera in hopes of finding
out whether it will rain next week.

That said, there is much of use in both men’s work, and
employing a strategy often used by Nassim Nicholas Taleb,
perhaps we can boil it down to the following rules of thumb:

Regulators and central bankers ought, in general, to behave
as if they believe Shiller, while investors, by and large, will
be far better off if they heed the lessons of Fama.

If both those rules of thumb had been followed the past 20
years, you, dear reader, would likely be living in a society
with greater economic output and less-damaging economic
volatility, while looking forward to a more secure retirement
due to having more in savings.

SHILLER FOR FED CHAIR

Remember Citigroup chief Chuck Prince’s comment, just before
the crash, about how you have to dance while the music is
playing? That was an acknowledgement of how commercial pressures
(and personal gain) prompt banks to keep pouring on credit even
when things seem to be getting out of hand. That this happens is
something well understood by Shiller, in a way Alan Greenspan
never understood, or never allowed himself to understand.

Greenspan, and other regulators and central bankers, bought
in to a kind of triumphalism that sees market finance as both
un-erring and self-policing. You can’t exactly lay this at
Fama’s feet, as it is a perversion of his work, but Shiller
demonstrated that markets make errors. His insight, that
psychology plays a key role in setting prices, was very much out
of the mainstream when he began enunciating it two or three
bubbles ago.

Had Greenspan, and others, made monetary policy and
regulated finance in a Shillerian spirit, with a keen eye on
greed and fear, we almost certainly would have had fewer
bubbles. It also follows quite naturally that in a world with
bubbles driven by irrational behavior you would force banks and
other key institutions to hold high levels of capital.

FAMA FOR CHIEF INVESTMENT OFFICER

Perhaps Fama’s biggest contribution to the happiness and
sanity, not to mention wealth, of the average investor is in
providing the intellectual underpinnings for the growth of the
index fund movement.

“Research generally has failed to find that mutual funds
generate positive returns above what can be motivated by the
level of risk; once fund fees are taken into account, their
asset management often yields negative excess returns,”
according to a statement from the Swedish Royal Institute of
Sciences, which chose the winners.

“The recent growth of index funds, which collect all stocks
in passively managed portfolios, follows that insight.”

Markets, Fama’s work in the 1960s tried to show, were the
distillation of all available information, making predicting
their future movements essentially pointless.

The takeaway, as far as you and I are concerned, is that
markets are efficient enough, enough of the time, to make it not
worth your while to indulge in active management.

Later work by Fama, who teaches at the University of
Chicago, backed away from the hardline efficient markets
world-view, finding that other stock traits, such as momentum,
can help to explain stock movements.

A 2010 paper Fama authored with Kenneth French of Dartmouth,
found that just 3 percent of mutual fund managers demonstrated
meaningful skill, about the same number as would be produced by
chance.

Three out of 100 doesn’t look like very good odds to me, and
so most people, in most circumstances, should lean heavily on
index funds for their investments.

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