investing

Is the Market Rational?

Nobel laureate Robert Shiller showed that fluctuations in the stock market were consistent with fads and euphoria.

Sweden’s central bank recently awarded the Nobel Prize in economics to Robert Shiller, of Yale University, and Eugene Fama and Lars Hansen, of the University of Chicago, for their research into the sources of price fluctuations in the stock market. I have known Bob Shiller for 47 years, first as a fellow PhD student at MIT, then as a colleague, coauthor and best friend. His Nobel Prize was an honor richly deserved.

Shiller’s work supported the belief that the financial markets are frequently irrational. So, many people thought it odd, if not downright confusing, that the prize was also awarded to Fama for his work in support of the efficient-market hypothesis, which states that prices always rationally reflect all the information that’s available about securities. On closer examination, the conclusions of Shiller and Fama aren’t as contradictory as they first appear.

Shiller’s most important contribution was his 1981 article titled “Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends?” His answer was a resounding yes. He showed that fluctuations in the stock market were consistent with fads and euphoria that had little to do with the fundamental factors that determine the price of an asset. Shiller’s work gave a boost to the behavioral finance wing of the finance profession, which challenged the theory of rational investors and efficient markets that most academics embraced.

Gene Fama, however, had been a strong supporter of the efficient-market hypothesis. And if its contention that securities prices reflect all publicly available information was correct, investing on the basis of widely known fundamental factors could not improve investor returns.

Yet Fama, along with Dartmouth professor Kenneth French, showed that contrary to the efficient-market hypothesis, there appeared to be publicly known factors—such as a company’s size, earnings, cash flow and book value—that could be used to predict stock returns. In a 1996 article, they concluded that their results could be “consistent with specific irrational-asset-pricing stories.”

What Fama and French found is what value investors such as Warren Buffett and Benjamin Graham have long known. If market prices do not always reflect fundamentals, then investors can indeed achieve superior returns by buying stocks when they are cheap and out of favor—when, say, their prices are low relative to a com­pany’s earnings, dividends or book value. In fact, Fama is a director and consultant for Dimensional Fund Advisors, a successful firm that manages more than $300 billion in portfolios that pick stocks according to specific criteria that historically have produced superior results.

Reacting to uncertainty. Although Fama seemed to open the door to irrational-asset-pricing stories, his own belief is that it is wrong to call these anomalies irrational. He says that we have yet to discover a more general theory to explain what we observe, just as the irregularities in celestial orbits first observed in the Middle Ages were eventually explained by the sun-centered view of the solar system.

The research of Fama and Shiller has challenged the profession to determine whether fluctuations in asset prices are better explained by psychological and behavioral factors or by a more general theory of how investors react to uncertainty. The Nobel committee concluded that both men have made progress toward this end. The committee also awarded the prize to Lars Hansen, who developed innovative empirical techniques to test whether the market is efficient. I was honored to have been invited to Stockholm to celebrate their awards.

Most Popular

Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
Resist the Impulse to Buy These 14 Holiday Gifts
shopping

Resist the Impulse to Buy These 14 Holiday Gifts

Don't let those holiday sale promotions persuade you into buying something now that will be much cheaper later.
November 18, 2021
Should You Take an Extra Big RMD This Year?
required minimum distributions (RMDs)

Should You Take an Extra Big RMD This Year?

Sometimes only taking the minimum IRA distribution can be a costly mistake. When deciding how much to withdraw this year, you need to consider the big…
November 23, 2021

Recommended

How Leveraging Alternative Assets and Modern Portfolio Theory Can Help Investors Improve Returns
investing

How Leveraging Alternative Assets and Modern Portfolio Theory Can Help Investors Improve Returns

To help manage risks and possibly boost returns, everyday investors should think about including alt investments in their portfolios. Here’s how to ap…
December 4, 2021
Investing for Income with Jeffrey Kosnett
investing

Investing for Income with Jeffrey Kosnett

Cold, hard cash working from home! No, this isn’t a scam — it’s an investing strategy built on bonds, REITs, preferred stocks and more.
November 30, 2021
Is the Stock Market Open on Thanksgiving and Black Friday 2021?
Markets

Is the Stock Market Open on Thanksgiving and Black Friday 2021?

Take your time with the turkey: The stock market will indeed be closed on Thanksgiving. But you will need to pay attention for a few hours on Black Fr…
November 24, 2021
The 13 Best Books for Beginning Investors
investing

The 13 Best Books for Beginning Investors

Do you want to start building your wealth? Consult this short list of the best books for beginning investors before you embark on your journey.
November 24, 2021