Shiller revolutionized our understanding of how stock investing works with the publication of his Nobel-prize-winning research showing that valuations affect long-term returns. If that’s so, stock gains beyond those justified by the economic realities are merely the product of irrational exuberance. Those sorts of gains do not last and should not be considered real for purposes of financial planning. In a post-Shiller world, we all should be careful to distinguish real stock gains from irrational exuberance. We should be checking regularly on changes to the CAPE value so that we can stay up to date re the true value of our portfolio.
I don’t know anyone who does that and I rarely hear people talk about doing it on internet discussion boards. Shiller’s work is widely respected. But it has had little practical effect. Today’s CAPE value of 34 underlines the point. In a world in which Shiller’s research was taken seriously, we would all be working together to keep the CAPE value as close to the fair-value CAPE value as possible. If we were thinking clearly about these matters, we would not want stock prices to get too out of hand. But we hardly even make an effort to rein in irrational exuberance. Often, we cheer on price increases, even those that take place at times when prices are already far too high.
What gives?
There are numerous factors at play. One big one is that the Shiller breakthrough represents such a huge advance in our understanding. If the market were efficient, as it was widely believed to be in the days before Shiller published his research in 1981, we could trust rational investors to set prices at reasonable levels. That would mean that we could trust the numbers on our portfolio statement to tell us where we stand financially and we could be confident that price increases signaled good economic developments. In a world in which irrational exuberance runs rampant, high stock prices are not only not a good thing, they are actually a bad thing. The higher prices go, the greater is the risk of a price crash and an economic collapse and the harder it is for anyone to plan their financial affairs effectively.
The implications of Shiller’s research findings
It’s a big difference. It is of course a good thing that we now can understand the realities better than we did before the research was published. But do we want to understand the realities? The reluctance that most of us feel to explore the far-reaching implications of Shiller’s research findings suggest that the answer is a resounding “no!” Why not?
Change is scary. Big changes are very scary.
Yes, it’s good to learn new things. Shiller’s research findings are important. That’s why we awarded him a Nobel prize and made his book a best-seller. It takes things a step further, however, to change our investing practices to bring them into line with what we have learned from the new research. To actually engage in combat with irrational exuberance would make this stuff real. From the standpoint of the Buy-and-Hold world that became dominant in pre-Shiller days, this new way of looking at things is disorienting. We are not sure that we are quite ready to enter the new world.
I believe that the Shiller world is the better world. The thing that has made stock investing scary in the past has been the crazy ups and downs of prices. Most of that goes away when we become accustomed to the new world. In the old days, the thought was that economic developments caused price changes. There’s not much that any of us can do about economic developments. The Buy-and-Hold Model made us passive observers of the roller-coaster ride of stock prices. If investor emotion is the primary driver of stock price changes, we have it in our power to greatly diminish price volatility just by getting our own emotions under better control.
That’s a better world. A much better world. But stepping into that better world is a disorienting experience. Most of us are not quite ready to accept the need to begin living in the better world. I believe that the day is coming when we will be. We’ll see.
Rob’s bio is here.
