Nobel Laureate

If You Can't Beat 'Em, Join 'Em

Nobel Laureate

"The current understanding of asset prices relies in part on rational investors and their concerns about risk and in part on psychology and behavioral finance."

2013 Nobel Prize Committee Announcement, October 14, 2013


“This year’s Prize in Economic Sciences honors empirical findings about the price movements of assets such as stocks and bonds,” announced the Nobel Committee as they awarded the 2013 Nobel Prize in Economic Sciences to Professors Eugene Fama, Lars Hansen and Robert Shiller.

At first blush, it’s a challenge to reconcile how the opposing viewpoints of Fama and Shiller could be awarded the same prize — at the same time.

Fama’s contributions to modern finance are pervasive — so much so that he is known as the “Father of Modern Finance.”  Fama’s share of the award is the result of his 1960’s work establishing that short-term stock prices are very hard to predict. He demonstrated how prices quickly reflect all known information—making it virtually impossible to identify mis-pricings in securities and exploit them for profit.  

Fama’s findings assert that markets are rational, and that the current price is the best estimate of a fair price. An investor who ascribes to rational and efficient markets theory would accept the futility of attempting to beat the market, and simply buy the market in the form of index funds. Fama’s findings actually sparked the birth of index funds, giving rise to a movement that has exploded over the last four decades when Fama’s findings resulted in the packaging of products that have been sold to investors the world over.

For Shiller’s part, he sits directly opposite from Fama on the subject of market efficiency, arguing that irrational investor behavior creates securities mis-pricings that can be identified through rigorous analysis and exploited for profit.  Shiller’s research in the 1970’s kicked off an area of study called “behavioral finance.” It’s an intriguing proposition -- one that begs analysis into the real-life implications and profit opportunities presented by market forecasts that may not be perfectly rational.

If Fama’s solution to investing is to accept that the market knows all that is knowable and that prices reflect all information, Shiller would contend that irrational investor behavior can cause the market to get it wrong, and a cool-handed savvy investor can profit from those mistakes or mis-pricings—paving the way for an esoteric form of active management that focuses on exploiting investor behavior and its impact on markets.

In the final analysis, all active management involves some form of market timing. Behavioral investing is no exception. A basic, if not overly simplistic explanation of behavioral investing would be when a fund manager views pessimism as a buy sign and optimism as a sell sign. The idea here is that investors are, as a group overly pessimistic or optimistic, leaving room for mis-pricings from irrational behavior.

Information on behavioral funds is spotty, at best. One publicly traded fund for which we were able to procure data is the Undiscovered Managers Behavioral Value Fund (UBVLX) managed by the firm Fuller & Thaler, whose principals (Richard Thaler and Russell Fuller) are highly accomplished members of the behavioral field—and even friends of Eugene Fama’s.  For the 10 years ending September 30, 2013, this domestic small cap value fund performed almost identically to DFA’s U.S. Targeted Value Fund (DFFVX) which is the basis of IFA’s Small Cap Value Index — a reasonable benchmark. Where it gets interesting, however, is the differences in investor returns, the dollar-weighted returns received by investors as a whole.

In an ironic twist, the results show the investors in the behavior fund --seeking to exploit other investors’ bad behavior --actually themselves displayed very bad behavior, obtaining only half the return of the fund itself. In a clear demonstration of good investor behavior, investors in DFFVX as a group actually achieved a higher return than the fund itself. To top it all off, UBVLX costs a full 1% more per year in the fund expense ratio compared to DFFVX.

Do investor emotions play into prices? Certainly. But, it is far too simplistic to think that one can outsmart the market, irrespective of what precipitated the trade in the first place.  Rex Sinquefield, one of the first to bring an index funds to the market perhaps says it best:

"Nobody knows precisely what causes markets to price securities and assets the way it does. Their opinions are factored in, but so are the opinions of six billion other people, and so the market is the only thing that possesses the implications of all the information and insight and preferences and actions of all six billion people in the world. So you can think of the system of market pricers as a vast processing machine that takes all of this information and brings it together." 

The main point here is that we do not need to know everything that goes into prices, but we injure ourselves financially when we second-guess that the price is right. Behavioral finance may go a long way in describing the very human element that is at play in the market. It’s only natural, we are in fact, all humans. But irrespective of the input of the price — it is still the price.

The fundamental question for an investor should be this: Whether markets are rational or irrational, what investment strategy delivers the highest probability of achieving investment success — defined only in terms of net-of-fees, risk-adjusted return?

In turns out that while the two Nobel Laureates we’ve discussed agree on little in terms of fair prices—they both agree the best way to capitalize on the returns offered by the market is through index funds.

Not such a radical notion according to another behavioral investing guru—Meir Statman who said, “People in behavioral finance and standard finance come to the same conclusion.  Don't try to beat the market. Whether it is rational, as people in standard finance say, or crazy, as I say, don't try it.”[1]  

And, despite Shiller’s commitment to market irrationality, he’s a fan of Fama’s efficient market research portfolios, which are brought to market by Dimensional Fund Advisors (DFA). 

In a recent New York Times article, Shiller said, "I can even recommend that people might consider investing in D.F.A."

So can we, Professor (and we do all day long).

[1] in SF article titled, Meir Statman: Amateur investors expect impossible”, 11/16/10