October 20, 2013

Lessons for Real-World Investing from Nobel Prize Winning Theories

The predictability of asset price movements was the theme of this year’s Nobel Prize in Economic Sciences. By awarding it to Eugene Fama, Robert Shiller and Lars Peter Hansen, the committee acknowledged the debate as to whether security prices are efficiently priced. It also recognized two men often viewed as being at different sides of the debate about market efficiency: Fama and Shiller. Most importantly, the lessons behind this year’s award have practical applications for individual investors.
University of Chicago Professor Eugene Fama created the efficient market hypothesis (EMH). This theory holds that new information is quickly priced into the asset prices. It is the foundation for the random walk school of thought, which views stock price movements as random and unpredictable. Under the EMH model, a stock’s price reflects all known information and there is no advantage to be gained from analyzing a stock or a bond.

Yale University professor Robert Shiller concluded price movements have some predictability over the long run. His researched showed that when asset valuations rise too high, prices tend to fall; conversely, when valuations become too low, prices to tend to rise. His cyclically adjusted price-earnings (CAPE) ratio has become a widely followed measure.
Who is right? The Nobel Prize committee said both men have valid points. Stock price movements are very difficult to predict. The inability of security analysis to give a consistent advantage explains why active fund managers have had such a difficult time consistently beating their benchmarks. At the same time, high valuations lead to lower price returns and low valuations lead to higher price returns, on average. This finding by Fama corresponds with Shiller’s work. Shiller shares common ground with Fama by suggesting investors look at long-term valuation trends and not the day-to-day movements of stock prices.

Lars Peter Hansen’s work is akin to a bridge between Fama’s and Shiller’s work. His mathematical method, the generalized method of moments (GMM), enabled the testing of asset price theories. His work, and additional research based on his method, found that applying modifications to financial theory helps to explain price movements.

The Nobel Prize website has a paper explaining their reasoning for giving the award to all three men. It’s a bit theoretical, though interesting.

From the standpoint of real-world investing, there are a few lessons to keep in mind. The first is that we individual investors are at an informational disadvantage. Particularly in today’s environment of high-speed computers, a significant part of important new information is priced in before we can place an order with our broker. The second is that valuation and size matter; going smaller in size and lower in valuation lead to better long-term performance. Third, and most importantly, Warren Buffett was right when he said “buy fear and sell greed.” Asset prices can and do reach irrational levels from time to time. Realizing when valuations are out of whack and acting accordingly is a very profitable strategy for those with the emotional tolerance and the patience to use it. 
The Week Ahead
Approximately 150 members of the S&P 500 will report earnings next week. Included in this group are many Dow components: McDonald’s Corp. (MCD) on Monday; Du Pont (DD), Travelers Companies (TRV) and United Technologies Corp. (UTX) on Tuesday; AT&T (T), The Boeing Company (BA) and Caterpillar (CAT) on Wednesday; 3M (MMM) and Microsoft Corp. (MSFT) on Thursday; and The Procter & Gamble Company (PG) on Friday.

September existing home sales and the final October University of Michigan confidence survey will be released on Monday and Friday, respectively. September new home sales and September durable goods orders are scheduled for release on Thursday and Friday, but because of the government shutdown, it is unclear when we will actually see them. The release dates for other economic reports delayed by the shutdown is also unknown as of this afternoon.

The Treasury Department will auction $7 billion of 30-year inflation-adjusted securities (TIPS) on Thursday.

Chicago Federal Reserve Chairman Charles Evans will give an interview on CNBC on Monday morning.
About The Author - Charles Rotblut, CFA is  the VP and Editor for American Association of Individual Investors (AAII).  Charles is also the author of Better Good than Lucky.  (EconMatters author archive here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters. © EconMatters All Rights Reserved | Facebook | Twitter | Post Alert | Kindle

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