Investing in the face of chaos (excerpt)

Brian Jacobsen

Three Americans were awarded the Nobel Memorial Prize in Economic Sciences. Dr. Brian Jacobsen, CFA, CFP®, chief portfolio strategist at Wells Fargo Funds Management, LLC, draws a line between their works and lessons for investors in this excerpt of On the Trading DeskSM from Friday, October 25, 2013.

Listen to the full interview.

Brian, who are the recipients of this award?
The Nobel Prize in economics was given to Eugene Fama of the University of Chicago; Lars Hansen, also of the University of Chicago; and Robert Shiller of Yale University, and it was a very interesting prize, as it seems to span the spectrum of approaches to looking at asset prices. On one side of the spectrum, you have Eugene Fama and his model that says markets tend to be really good at setting prices; that’s called the efficient market hypothesis. On the other side, you have Robert Shiller, who says that really dumb stuff can happen in markets driven by emotions and psychology; that area is called behavioral finance. Spanning the two ends of the spectrum, you have Lars Hansen. His work is very technical; he developed techniques for testing these different theories.

Let’s go right down the list and discover what these gentlemen accomplished and what lessons investors can glean from their work. First was Eugene Fama. What was his area of study?
Fama is most famous for his work on the efficient market hypothesis. Basically, it says that financial markets are incredibly competitive and they incorporate information and expectations of the future very quickly. He was also one of the first critics of his own work—which is quite interesting—showing how there are anomalies that deviate from what his theory would predict. His theory doesn’t say that market prices are always correct, but it does say that it’s probably a good idea to start with the assumption that they’re right and then go from there.

Can you give us an example of this?
Yes, look at how stock prices move very quickly on any type of news and sometimes not on news. This is due to how competitive markets are and demonstrates how quickly prices reflect new information and also new expectations that people have about the future.

What’s the lesson for investors then?
Unless you have a unique set of information or a unique way of looking at the world that ends up being more correct than the consensus, you’ll find it very difficult, if not impossible, to do better than your average investor. That’s why we have professional investment managers who bring unique and informed perspectives.

Next, we have Lars Hansen; what was his contribution?
Hansen developed some very powerful statistical techniques that deal with asset price data, which can be very annoying, meaning that there tends to be a lot of randomness to the movements of asset prices that we can’t really explain with a lot of different models. Now, his is the most technical work but perhaps the most important, as it has application outside of investing. His theories about statistical technique have been used in all areas of the social sciences. It revolutionized data analysis. I personally am a big fan of Hansen for some of his later work that models and measures systemic risks and integrates asset-pricing models with macroeconomic models.

Finally, we have Robert Shiller, a name I associate with the Case-Shiller Home Price Index. Is it one and the same, and for what contribution was he awarded?
It is one and the same. Shiller is perhaps most famous not only for that index he created and his work on the housing market but also for his work in the area of behavioral finance in general. The Nobel Prize was given to him for his work on the long-run predictability of asset prices showing, basically, in the long run, valuations really matter for assets. In the short run, over the course of minutes to months, valuations might not matter all that much, but over the span of years, they really do. He was also given appropriate recognition for his work in behavioral finance and the idea that emotion and psychology play an important role in determining market prices. Interestingly, his wife is a psychologist, and I cannot help but think that she deserves some of the credit here, that she likely influenced some his thinking and interest.

Can you give us an example of his work?
Shiller pointed out that market prices can sometimes be wrong, and they can be wrong for extended periods of time. We saw this during the technology bubble in the late 1990s when stocks weren’t generating any revenues and it really seemed as though the prices were deviating from the fundamentals of the earnings or the dividends that the companies were going to be generating. We also saw this with home prices during the housing bubble.

How does his work help us invest in the face of chaos?
People are emotional; even if you are convinced and absolutely certain that you are right, that might not matter much in the short run if everyone else is losing their heads.

This has been very interesting, Brian. We have a moment remaining and would welcome a parting thought.
The world is constantly changing. There will always be something to be worried about and something to be excited about in the market. If you’re looking for certainty, you’re probably not going to find that in the market. Investing entails taking on risks, and when it comes to risks, it’s incredibly important to stay informed about what those risks are to keep them in a proper perspective.

That’s it for this week, Brian. Thank you.
My pleasure, as always.

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