The Nobel Prize in economics took a strange twist this year. Lars Peter Hansen is an uncontroversial choice, respected for his complex econometric tests. But the other two Nobel economists are definitely strange bedfellows.
Robert Shiller is best known for his work on understanding irrational investor behavior in the markets, including the emergence of bubbles. In sharp contrast, Eugene Fama is a pioneer in developing the efficient-market theory, the notion that the market price of equities, fixed-income securities, commodities and other assets reflects everything investors know about its value at the time. Market prices change in response to new information, meaning investors can’t systematically outperform the market. Bubbles don’t really exist in this worldview.
The core of the efficient-market theory is the assumption that investors are rational. Yet investors are far from the rational thinking machines described in finance textbooks. Behavioral economists like Shiller and economic historians such as the late Charles Kindleberger are right: Emotions, fads and biases deeply shape investment decisions.
For example, many people become too confident of their investment ability when markets are strong and too fearful to place a bet when markets plunge. (Think of the dot-com and the real estate booms and busts.)
Nevertheless, embracing the insights of behavioral economists doesn’t mean it’s easy to beat the market. The efficient-market theory skepticism that everyone from brokers to hedge fund gunslingers can outperform the market year-in and year-out is spot on. Yes, Warren Buffett has an incredible stock-picking track record. So does his investing partner Charlie Munger. The track record of the American Funds managed by Capital Research and Management Co. is impressive.
Still, most money managers fail to do better than the market indexes — with good reason. Investing is the most competitive business in the world, with astronomical sums changing hands every day around the globe.
Thing is, lost in much of the heated rhetoric about rationality and irrationality is how much scholars on different sides of the debate agree. Fama has done important work poking holes in the efficient-market theory while Shiller wants to broaden and deepen the financial markets to make them more efficient.
More important, economists from the behavioral school and supporters of efficient markets essentially agree on a set of practical investment principles for individuals. Both schools of thought believe the evidence is overwhelming that it’s hard — really hard — to beat the market.
The right default assumption is that the actively managed mutual fund pushed by a broker or financial adviser can’t and won’t do better than a market index over time. Active trading by individual investors is hazardous to their wealth. We may all love the lure of returns but risk is the truly critical concept. Low-cost, broad-based equity and bond index funds are the best way for most people who don’t work on Wall Street to invest in their 401(k) and other retirement accounts. Keeping money management fees razor thin, building a diversified portfolio and steering clear of high-priced professional investors is a savvy strategy for most individuals.
From the point of view of households managing money over a lifetime, what I find striking is that Fama and Shiller don’t differ much.