Winners of the 2013 Nobel Prize in Economics are three professors – Eugene Fama, Robert Shiller and Lars Peter Hansen – who collectively pushed forward economists’ understanding of asset prices.
Fama invented the efficient market hypothesis (EMH) which says that liquid asset markets like stock markets are efficient in the sense that relevant information is fully and immediately incorporated into stock prices, with the implications that stock prices move randomly as random pieces of information are received, and that effort spent trying to predict future stock price movements is almost surely useless. Naturally, this conclusion did not sit well with professional investment managers who were basically told that their economic contribution was negative (they charged fees for activities that were useless). But this conclusion created a paradox – if it weren’t for the activities of professional investors, how would new information get incorporated into stock prices? And if there were no positive return to this activity, why would people engage in it? Eventually economists came around to the understanding that markets are pretty efficient, but not completely so.
Even though economists grudgingly allowed that professional investors may have a useful role to play, the data suggest that on average the performance of active mutual fund managers lags behind the performance of passive market indexes, after deduction of management fees. Again, when you think about it, this conclusion is not all that surprising. Since the bulk of investments are run by professional managers, in the aggregate they are the market. So, it must be the case that in the aggregate they will underperform net of fees. This realization gave birth to the creation of passively managed index funds that provide market returns at very low cost. These funds are available to retail investors and enable Mom and Pop to achieve investment returns that surpass that of the average actively managed mutual fund. Index funds are an important financial innovation that came about in large part due to Fama’s research.
However, although such passively managed index funds have been around for 30 years or more, they still do not constitute a large fraction of retail investors’ portfolios. Taking a longer view, maybe that is just as well; if a majority of assets were moved to passive accounts then these markets might become less efficient, with negative consequences for resource allocation.
A possible reason for slow adoption of a superior investment product has been suggested by Shiller, namely, people are not rational. Shiller looked at the volatility of stock prices and proved that stock price swings are suggestive of irrational boom and bust cycles rather than rational analysis of incoming information. While Shiller agrees with Fama that stock prices are not predictable over the short-run, his research suggests that stock prices are at least somewhat predictable in the long-run. This is because they tend to “mean revert” from irrational highs and lows and move back toward fundamental value. This provides an economic basis for active market timing by investment professionals and for the concept of “rebalancing” for small investors. Rebalancing involves selling stocks to maintain your target asset allocation after major stock price increases and, conversely, buying stocks after major market setbacks.
Although the re-balancing idea has the support of economists and many investment advisors, it is not easy to carry out. In particular, after a major market downturn, as occurred in 2009, it is very difficult to jump into the market to buy stocks. Instead the natural tendency is to sell everything so as to prevent further losses. The legendary investor Warren Buffett is immune to this “natural tendency” and tends to buy most aggressively after market declines (like 2009). Aside from those periods, he spends a lot of time thinking, looking for attractive purchase opportunities. He famously characterized the normal pace of activity at Berkshire Hathaway’s corporate offices as “lethargy, bordering on sloth.”
Another take on the rebalancing idea is found in a story related by Robert Kirby, the former head of the large equity management company Capital Guardian. Kirby was managing the portfolio of a wealthy woman whose husband also had substantial assets, but did not enlist Kirby’s advisory service. Eventually the husband died and Kirby was asked to be trustee for the estate. He was shocked when he reviewed the husband’s portfolio. It turned out that every time Kirby recommended buying a stock for the wife, the husband would buy the same stock for his own portfolio. However, every time Kirby recommended a stock sell for the wife, the husband ignored that advice and simply held on. What was shocking was not so much that the husband had “free-ridden” on Kirby’s buys, but rather that the performance of the husband’s portfolio dramatically outstripped the wife’s! The key difference was that the husband’s portfolio was dominated by a few big winners, like Kodak, that had gone up 10-fold or more. Kirby concluded that expert stock managers, like himself and his company, were much better at making buy decisions than sell decisions, and concluded that the best way to manage a portfolio is what he called the “coffee can” approach. Simply buy a portfolio of stocks, put the shares into a coffee can (this was back in the days when physical stock certificates were held by investors) and forget about them.
The coffee can story supports the idea of buying when prices are low, hence rebalancing after a market downturn, but not the idea of selling when prices are high. Perhaps the difficulty of making smart sell decisions is that there is a strong long-term upward trend in stock prices, so trying to call a top is hazardous.