‘It’s hard to beat the market, and you should probably be suspicious of people who claim to be able to pull off the trick’
At last, they’ve given out a Nobel memorial prize in economics for something that could make money for you and me. Eugene Fama and Robert Shiller have, between them, saved me many thousands of pounds. (Lars Peter Hansen, who shared this year’s prize with Fama and Shiller, developed statistical techniques that, I’m sad to report, have never made me a penny.)
There have been practical prizes before, of course. Only last year, Al Roth shared in the prize, in part for his work designing ways in which possible kidney donors and recipients could be matched with each other for maximum advantage. Ronald Coase, who won in 1991 and died this September, inspired markets to control pollution. And Thomas Schelling, a winner in 2005 for his wily and practical take on game theory, arguably helped prevent the cold war turning into something more catastrophic.
But hard cash in my pocket is something else. And the odd thing is, Fama and Shiller disagree with each other.
Fama’s most famous contributions have been in refining and testing the idea of efficient financial markets. The efficient markets hypothesis, or EMH, is much maligned, so let me state it in the form that has spared me anxiety and saved me money over the years: it’s hard to beat the market, and you should probably be suspicious of people who claim to be able to pull off the trick. As Fama himself told me in a rare interview for the BBC last week: “People spend lots of money … trying to hire managers that can pick stocks although the evidence says quite conclusively that that is probably impossible to do.”
But let’s consider two reasons why we should treat the EMH with scepticism. The first is that it may have led regulators astray by encouraging them to leave markets alone when they should have intervened. Maybe the EMH is a better guide for investors than it is for regulators – although I feel allowing excessive leverage was the ultimate regulatory sin before the crisis, and one not closely connected with the EMH.
But a second reason to disbelieve the EMH is the experience of the dotcom and subprime bubbles. “I don’t even like the word,” says Fama. “If your meaning of the word bubble is that prices went up and then went down, that’s fine. But if your meaning of the word is that prices went up and then it was predictable that they would go down, then I don’t think there’s any evidence to support that.”
Shiller would disagree. He is the pioneer of “behavioural finance” – putting psychological factors back into a study of market behaviour. And a single graph drawn by him saved me from being swept up in the dotcom mania.
Shiller simply plotted a standard measure of stock market valuation – the price/earnings ratio – but rather than looking at a single year’s earnings he looked at average earnings over a decade. The resulting graph showed a huge peak in 1929 – just before the Wall Street crash – that is unique in market experience between 1880 and 1995. Then in the late 1990s, a far larger peak built. In 2000, I showed this graph to many people – and stayed out of the market. It saved me a lot of money.
Of course, it is hard to reconcile Shiller’s conclusions with Fama’s. But when I spoke to Shiller last week, he summed up the tension rather well: “It’s a little bit like religion, you know. There’s all these different sects and, when you look at them in the whole, it doesn’t seem to make any sense, they contradict each other so fundamentally. But maybe there’s some wisdom about living that comes out of all of them.”
That may sound a little far out but in my experience it has proved absolutely true.
Also published at ft.com.