Building a Nobel Portfolio

What an unlikely pair of laureates can teach us about how to invest

The economics world is abuzz with the announcement of this year’s Nobel Prize winners, Robert Shiller and Eugene Fama. Much of the buzz stems around the unlikely pairing, which is a bit like Barack Obama and Ted Cruz being jointly selected as health care reformers of the year.

What is lost in this narrative is that Fama and Shiller have together constructed a blueprint of how to invest rationally that much of the industry (and the overwhelming majority of individual investors) still ignore at their own peril.

Fama’s fame comes mainly from constructing something called the Efficient Market Hypothesis (EMH), which argues that market prices instantaneously incorporate all known information. Shiller’s fame comes mainly from disproving that same theory, by empirically showing that markets go through booms and crashes that have more to do with waves of fear and greed than they do with the efficient and emotionless assessment of new information by rational actors.

But while EMH as some kind of “grand theory” has been tried and found lacking, many of its biggest implications are as valid as ever, and have actually provided a firm foundation for innovators like Shiller to build on top of.

Fama’s lasting legacy to individual investors will be the ideas that:

• Beating the market is a zero-sum game. In aggregate, the collection of investors trying to pick stocks that will go up more than the overall market cannot possibly succeed, because together they make up that market. After accounting for fees, the average investor will always lose to the market.
• If you enter this zero-sum game, you will therefore be directly competing with thousands of smart, highly motivated, full-time professionals. Unless you have some kind of edge (conceivable, but most are looking in the wrong places), you are more likely than not to be eaten for lunch (which is not the same thing as a free lunch).

Putting these together, it is no wonder that the available data strongly indicates that the penultimate actionable conclusion from EMH is empirically true, even if some of its supporting theory is not: for the average individual investor, buying the market through low-cost index funds or ETFs usually is a vastly superior strategy to attempting to select stocks on your own, or even paying an over-compensated mutual fund manager to do it for you. Over five year periods, roughly 70% of mutual funds fail to beat the market (source: SPIVA). The average retail investor fairs even worse.

None of Shiller’s work has changed that. In fact, even Warren Buffet agrees that most investors would be better off in low-cost index funds and ETFs that track the market (and for his part, Fama is generously at least open to considering the possibility that Warren Buffett might possess some kind of investing skill… maybe).

But if Fama gave us a foundation of rational investing, he didn’t quite build the whole house.

Those that take EMH literally believe that they can pay no attention to the market and own the same proportion of stocks and bonds for eternity. They will probably come out okay in the end, but they will also see some brutal whiplashes along the way. A Fama portfolio would have stayed in the market in 1999, when valuations were going through the roof, and it would have gone over the cliff right along with Lehman Brothers and AIG in 2008.

The argument from the EMH camp is that these kinds of bubbles and bear markets can only be reliably predicted in retrospect. Sure, we can say now that there was a tech bubble in 1999 and a financial crisis in 2008, but neither of these was quite so clear at the time. Timing the market, the EMH crowd will tell you in a voice that most people reserve for talking to children, just doesn’t work and will cost you in the end.

This is where Shiller’s contributions come in. Shiller definitively proved that not only do markets in aggregate deviate fairly significantly from “fair value” in both directions, but that this deviation is actually predictable using even simple measures. Using a straightforward measure of long-term valuation known as the “Shiller PE Ratio” (which was actually first suggested by Warren Buffett’s mentor, Benjamin Graham) as a timing mechanism, an investor could have mitigated the worst bubbles and bear markets over the last 80 years, and out-performed a pure buy-and-hold strategy over the long term. Market prices, in other words, do not follow a “random walk.”

Combine that with other well-known market anomalies like momentum (the tendency of prices to move in trends), and you can build an asset allocation system like this one, which has historically beaten the market by 2 or 3% a year while taking on significantly less risk.

It is together then, that Fama and Shiller’s contributions provide the blueprint for a truly rational, data-driven, and theoretically sound approach to investing. It’s one that takes low-cost indexing from Fama, and adds a data-driven dynamic asset allocation element from Shiller. The resulting portfolio is low-cost, diversified, tax-efficient, and built to withstand bubbles and bear markets. Its a portfolio that stands up as well in the real world as it does in the economics textbooks.

I’m not sure this is quite the message that the Nobel committee had in mind, but it is an important one to hear for an investing industry that still needs to break the habit of recycling stale theories from the 1970s and declaring them “disruptive innovations.”