Wednesday, October 16, 2013

Lessons from the Economics Nobel. We're less expert than we think

Wednesday column

Whether you’re standing in a queue at the supermarket, wondering whether to change lanes on the Harbour Bridge or making a big decision such as whether to buy or sell shares, take some time out of your day today to give thanks to the winners of this year’s Nobel Prize for Economics.

Eugene Fama, Robert Shiller and Lars Hansen have helped you in ways you might not even realise - all the more so because on the surface it seems they have been merely disagreeing, as economists often do.

We owe the greatest debt to Fama, passed over by the Nobel committee for decades until Monday night.

He demonstrated rigorously that if the supermarket crowd is big enough or if there are enough cars on the highway you will get no advantage from changing lanes. Anyone who could have been helped will have already helped themselves.

His groundbreaking 1969 study examined what happened to the price of shares as soon as there was a new piece of information that could have moved the market. It did, near instantly. Anyone trying to buy the day after good news (or by extension minutes after, or these days microseconds after) would be wasting their time. The good news would have already pushed up the price.

At one level it’s reassuring. There’s no point in switching stocks. At another level it is profoundly disturbing, so disturbing that most of us find it hard to accept the implication - no-one, not even the experts our super funds pay well, can pick stocks. All of the information that would have helped them guess how prices will move has already moved prices. Their guesses about what will happen next are no better than random.

Which isn’t to say that the experts don’t look good. SuperRatings says in the year to August Australian fund managers made an incredibly impressive 15.9 per cent. Over the same period the total share market climbed 21.7 per cent. Without putting too finer point on it, our fund managers would have done better had they sat on every share in the S&P/ASX 200 index and done nothing. Of course some of their investments are outside of the ASX 200 and in some years they outperform the market, but the point confirmed in study after study after 1969 is that on average stock pickers do no better than the market. More disturbingly still, the experts that do outperform in one year tend to underperform the next. Past performance is literally no guide to future performance, both for stocks and for the people who pick them.

And the mere process of chopping and changing appears to leave us worse off. In the American Economic Review Ilia Dichev of the University of Michigan used 20 years of data to compare the returns investors actually made buying and selling stocks to those they would have made had they had simply hung on to a basket of stocks.

In 18 of the 19 international stock markets he examined investors had harmed themselves by buying and selling. In Australia in the 20 years to 2004 the overall market grew in value 12.3 per cent a year. The amount Australian investors actually made was 11.7 per cent.

I am prepared to accept you find this hard to believe. It’s as if we are hardwired to believe in expertise...

But Fama’s findings have long since counted where it mattered. He ushered in a new era of index-linked funds management where funds did indeed do no more than sit on the index and have saved themselves the expense of hiring experts to advise them how to outdo it.

His work could be said to have stood the test of time, were it not for apparently contradictory finding of Robert Shiller, with whom he shares the Nobel Prize.

Shiller found that there are indeed predictable patterns in share market and other prices, but they are predictable over years rather than months or days. What is unpredictable in the short term turns out to be predictable in the long-term. If you think that’s odd, try drawing a graph of a wave that moves slowly up and down over the time and then make it wiggle unpredictably day to day. There are times when share prices are high relative to the underlying dividends (Shiller coined the phrase “irrational exuberance”) and long periods when prices are low. Working out why this should be so is where the third winner Lars Hansen comes in. He developed and is using a heavy-duty technique called the generalised method of moments.

Australian economists Richard Holden at the University of New South Wales and Justin Wolfers at the Brookings Institution summed up the findings online as being that financial markets are efficient (Fama), except when they’re not (Shiller), and that we have empirical evidence to prove it (Hansen). But the insights run deeper. Learning about markets and things such as our behaviour in queues tells us much about ourselves - our weaknesses , our strengths, our foibles and our incredible ability through the use of disciplines such as economics to come close to making sense of it.

In The Canberra Times, The Sydney Morning Herald and The Age

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