Oct 282013

It was not a bad choice, I must say, when, some years ago, I picked the topic of my DPhil thesis. It was built on this paper, which earned Robert Shiller this year’s Nobel Prize in Economics:

If prices are nearly impossible to predict over days or weeks, then shouldn’t they be even harder to predict over several years? The answer is no, as Robert Shiller discovered in the early 1980s. He found that stock prices fluctuate much more than corporate dividends, and that the ratio of prices to dividends tends to fall when it is high, and to increase when it is low. This pattern holds not only for stocks, but also for bonds and other assets.

The main aim of my thesis was to show the shortcomings of the Efficient Market Theory, which, funnily enough, earned Eugene Fama the same prize!

As John Kay wrote on the FT, it was like “awarding the physics prize jointly to Ptolemy for his theory that the Earth is the centre of the universe, and to Copernicus for showing it is not”. More accurately, it was like giving the prize to Galileo Galilei and to Cardinal Bellarmine (as per my first Tweet!). Because the EMT works like a Faith: a prior belief that no amount of evidence, however strong, can change.

Eppur si muove – said Galileo, according to the legend. The same kind of heroic defiance was needed – until well into the 1990s and, to a certain extent, it is still needed today – to question the domineering EMT consensus in academics. Robert Shiller has played a key role in breaking that consensus.

I have great admiration for Professor Shiller. Students with a serious interest in Finance should drop everything else and follow his Financial Markets course, unbelievably available online for free. And rather that wasting time Occupying Wall Street, anybody with a smart social conscience should read his most recent book, Finance and the Good Society. And, who knows, reading the book maybe even Cardinal Fama could learn a bit of common sense:

Ultimately, the idea that investment managers as a group are “frauds” because they cannot as a group outperform the market is mistaken. They are providing a multitude of services, including honestly watching over portfolios with sympathy for the needs of their clients – and the better among them apparently are outperforming the market. The intellectual community that they provide also constitute an externality that benefits society, in directing resources and incorporating information into market prices. In the future, better regulation and better financial advice for general investors can help improve the overall state of the investment management industry. (p. 36)

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