Robert Shiller: Against the Efficient Markets Theory

On March 26, David Wessel published a very interesting interview with Bob Shiller, “Robert Shiller’s Nobel Knowledge.” This interview gives a reasoned critique of the Efficient Markets Theory.

Ideal Informavores or Lovers of a Good Yarn? To begin with, Bob questions whether it is a reasonable approximation to assume that people acquire information avidly and process that information perfectly:

The story about bubbles was that the markets appear random, but that’s only because markets respond to new information and new information is always unpredictable. It seemed to be almost like a mythology to me. The idea that people are so optimizing, so calculating and so ready to update their information, that’s true of maybe a tiny fraction of 1 percent of people. It’s not going to explain the whole market.

Instead, Bob argues that human beings are avid consumers and tellers of stories:

Psychologists have argued there is a narrative basis for much of the human thought process, that the human mind can store facts around narratives, stories with a beginning and an end that have an emotional resonance. You can still memorize numbers, of course, but you need stories. For example, the financial markets generate tons of numbers—dividends, prices, etc.—but they don’t mean anything to us. We need either a story or a theory, but stories come first.

Can You Earn Supernormal Returns? A failure of Efficient Markets Theory suggests that there should be some way to obtain above-normal returns. But Bob cautions that believing that you personally can earn above-normal returns in the stock market is a little like believing one can win American Idol: definitely true for someone, not likely to be true for you:

The question is often whether it’s possible for anyone to pick stocks, and I think it is. It’s a competitive game. It’s like some people can play in a chess tournament really well, but I’m not recommending you go into a chess tournament if you are not trained in that, or you will lose. So for most people, trying to pick among major investments might be a mistake because it’s an overpopulated market. It’s hard. You have to be realistic about how savvy you are.

By contrast, if you want to try your hand at investing in a market where you have less competition as an investor, you have a better chance, with a lot of hard work:

But if you are thinking about buying real estate and renting it out, fixing it up and selling it, that’s the kind of market that’s less populated by experts. And for someone who knows the town, that’s doing business, I’m not going to tell someone not to do that.

Can Bob Shiller Earn Supernormal Returns? Bob does think that he can pick stocks. The key for him is to pick boring stocks:

Well, I actually think I’m smart enough to pick winners. I’ve always believed in value investing. Some stocks just get talked about, and people pay all sorts of attention to them, and everyone wants to invest in them, and they bid the price up and they are no longer a good buy. Other stocks, they are boring. There is no news about them—they are making toilet paper or something like that—and their price gets too low. So as a matter of routine, you buy low-priced stocks and sell high-priced stocks.

I think of “pick boring stocks that have a present value that can be easily calculated” (and of course only those that are undervalued according to that calculation) as Warren Buffett’s strategy as well.

Can You Succeed at Contrarian Market Timing? The one thing I would add here to what Bob says is this about market timing. Some of Bob’s work, some of it joint with John Campbell, suggests that contrarian market-timing can be a good idea. In particular, their work suggests increasing one’s stock holdings when the price/dividend ratio is low and reducing one’s stock holdings when the price/dividend ratio is high. (Bob has also used the ratio of price to cyclically adjusted earnings or smoothed earnings as a way of gauging if the market is high and likely to fall or low and likely to rise.) I believe this works and try to do it myself. But it is hard to do without a contrarian personality. What makes the market too high is that some story is making people optimistic about the market–a story that is likely to infect you as well; what makes the market too low is that some story is making people pessimistic about the market–again a story likely to infect you as well. So doing any market timing subjects you to the danger of succumbing to the stories out there that, because most other people are succumbing to them at the same time, will make you likely to buy high and sell low. It is only if you naturally like stories other people don’t like and dislike stories that they like that you can be a contrarian investor without great intellectual and emotional self-discipline.

Update: There were many great comments on the Facebook version of this post. The discussion with Robert Flood I am making into the post for Friday, April 18. Let me put the key elements of my discussion with Dennis Wolfe and Richard Manning here:

Dennis Wolfe:  Miles – enjoyed both your post on Saturday and this one – and I tend to believe both, especially Shiller’s points. Have you seen the whitepaper “Capital Idea: The active advantage can help investors pursue better outcomes”? The paper was published late last year by The American Funds to make a their case for active investing over passive investing. Their paper presents strong evidence that some investment managers have a proven model and track record of persistent above average results over rolling periods of time. John Rekenthaler (The Rekenthaler Report), a researcher at Morningstar, published results of a similar study last summer comparing American Funds with Vanguard index funds (The Wrong Side of History; The Horse Race) with similar conclusions. After considering Shiller’s thoughts and the evidence outlined by American Funds and Rekenthaler, I am much more persuaded against the efficient markets theory. I’d be interested in your thoughts.

Miles: The theory is pretty clear that if there is any departure from the efficient markets theory, most people (or people holding a majority of the risk-tolerance weighted money) have to be getting it wrong. Thus, believing that the efficient markets theory is not right makes me *more* skeptical of active investing. When most investors are getting it wrong, one would have to be doing something unusual to be getting it right.


Thank you, Miles. Active management, the argument goes, is unable to outpace a respective index because of the efficient-market hypothesis.

From the Capital Group whitepaper:

Those who adhere to that theory contend, in brief, that all information is reflected in a firm’s share price, making it impossible to beat the market consistently. But much of the literature in favor of index investing uses “the average active manager” to make the point. And indeed, in aggregate, U.S. equity active managers have not consistently outpaced the Standard & Poor’s 500 Composite Index. …

We believe this is a flawed way to frame the issue, akin to concluding that because the

average person cannot dunk a basketball, no one can dunk a basketball. Obviously,

some are playing at a higher level, and using the average to characterize an entire

industry obscures the fact that there are investment managers that have consistently

added value over a variety of market cycles,

Both studies I referred to in my earlier post demonstrate there are investment managers that have consistently added value over a variety of rolling time periods and market cycles - that is more than talk show chatter. I think it’s important to focus on the qualities associated with success like the contrarian and fundamental value points discussed by Robert Shiller but also including low fees, experience and global research.

While I certainly believe someone like you or Robert Shiller are capable of consistent success, I am skeptical the average person can consistently produce above average results on their own, especially since the average professional investment manager apparently does not (at least after fees). However, I don’t believe that proves the efficient market theory. When there is evidence investment managers that focus on disciplined qualities of success do consistently produce above average results after taxes and fees, then I believe the efficient market theory is hollow. And, If they do it, an average investor can still indirectly succeed by adopting their model by using their funds.

Miles: I am more drawn to the fact that since so many people invest so much money through professionally managed funds, most people putting their money in the hands of professionals must also be doing it wrong, so letting a professional handle one’s funds is no panacea. And that is before paying significant fees, which makes the mistake much worse. The advantage of putting money in low-fee index funds (my Fidelity Spartan accounts have a 0.1% annual fee) is that there is a bound on how far wrong one can go if one comes as close as possibility to holding the universe of accessible risky paper assets in proportion to market capitalizations. The only way to do better than holding a broad set of low-fee index funds is to do things that most investors don’t do when they try to go beyond that. And most investors are more like most investors than they think.  

Dennis:Miles, thank you, again, I appreciate your honest, objective thinking on this and the comments of Robert Flood. I must admit It is more difficult for me to completely understand this issue from economist’s point of view without that background. As a practicing CPA and now CFP, I often think about this practical issue for my clients and want to learn as much as I can, including how to sort through the intense marketing claims from both sides that cloud it. Since moving to the full time practice of financial planning about 14 years ago, I have been most influenced by the principles and work of Benjamin Graham, Burton Malkiel and Charles Ellis. My experience is few investment firms put clients’ interests central to their process and approach. I believe most are simply “commercial” and this is the main reason people are attracted to low cost index funds - not because of the efficient markets theory. In other words, I believe some people will (perhaps should) accept a C rather than seek an A or B when doubt or lack of trust exists. Despite the trust issues that exist in the financial services industry, I believe we should not ignore those firms whose processes consistently produce above average results, after fees and taxes, over rolling periods of time and market cycles. They do exist. However, where doubt exists and as a hedge, I am also also inclined to sometimes use low cost index funds or ETFs for myself and for clients.

A few other thoughts: I generally believe equity markets are more efficient in the U.S. than outside the U.S. - and the evidence is appears overwhelming in that space by objectively examining results. I also believe markets are more efficient for large companies over small and mid-size companies where quality proprietary research seems to yield comparatively better results. And finally, to Shiller’s point, I also believe inefficiency exists because most of us are attracted to interesting stories over “boring” stories. In summary, I continue to be persuaded there is room (given the right process that also puts an investor’s interest central) to produce consistent above average results over time. At the same time, I agree with you that most investors (including me) are more like most investors than we want to admit.

Richard Manning Whether Schiller or others believe the market is technically efficient or not on a moment by moment basis the practical advice for the vast majority is the same: buy and hold a diversified portfolio. No? So why the fuss?