Chapter 6: Robert Shiller: “The People’s Risk Manager”

Ø The framework of Capital Ideas:

n Its structure provide for innovative thinking and application.

n Can be a workhorse for some sensible research, if it is used appropriately.

n It can be a starting point, a point of comparison from which top frame other theories.

Ø When one does produce a model, in whatever tradition, one should do so with a sense of the limits of the model, the reasonableness of its approximations, and the sensibility of its proposed applications.

Ø Shiller is ultimately in the same camp as Merton and Lo – concentrated on institutions, what they do, how they do it, and why they change.

Ø Rational expectations hypotheses:

n Individuals do not simply extrapolate past experience in formation of expectations, to avoid being leaded astray.

n In forming expectations, they make use of all available info (and they understand how to interpret it).

n As such, average opinion is going to be as close to a correct view of the future.

n While average opinion will not correct all the time (due to possible surprises), it will never be systematically wrong – neither too optimistic all the time or chronically pessimistic.

Ø Rational expectations and EMH assumptions permit a theoretician to build models that are neat, with no fuzziness around the edges, with consistency between the whole and the parts, convenient to express and manipulate mathematically.

Ø In a surprising number of cases, these assumptions turn out to be a fair description of reality.

Ø Volatility is the key variable in Shiller’s work:

n Volatility is a vivid indicator of how ignorant of the future we are and how emotionally we respond when the future arrives and fails to conform to our expectations.

n Volatility means people are changing their minds about the future almost from moment to moment (due to new info arrival that is different from their expectations.).

Ø Rational expectations model may explain how people should think about the uncertain future, but the model tells us nothing about how they actually do think about the future as they go on about their business from day to day.

Ø We can only guess. We never have all the available info. The whole process is so difficult, and the odds on being wrong so daunting, that we let our emotional anxieties get in the way (or lean on the heuristics).

Ø The key to how volatility reveals the messy process of decision making in the capital markets is in the magnitude of the swings in security prices relative to the changes in the underlying fundamentals.

Ø All investors are in the forecasting business, whether they like it or not and whether or not they even recognize it.

Ø Too often people are critical of the realism of theory and blame the theoretician for living in the clouds. However, Fama did not assert that EMH is the way the world works. He was explaining how the world would work in a market that is efficient in processing info.

Ø Shiller: “If prices fully reflected all available info, the variability in stock prices would be less, or at the very least not significantly greater, than the variability in the underlying fundamentals.”

Ø Shiller’s tests revealed a consistent pattern of excess volatility. The appraisal of volatility is a key indicator of market behavior, because “excess volatility” means there are times when the markets are “too high” or “too low”. If we can actually identify when stock prices are too high or too low, what the market is going to do become predictable.

Ø Andrew Lo and Craig MacKinlay: “But just something is predictable, we are not guaranteed the ability to predict it correctly.”

Ø At best, forecasting major market moves – or market timing – is a notoriously trying activity even when you are right.

Ø Waiting for the market to correct itself takes longer than most of the bulls or the bears expect, to a point where they are constantly tempted to throw in the sponge too soon and join the other side.

Ø On the other hand, the effort to pick individual stocks can sometimes work – or wipe you out – in a day.

Ø Kurz: “Investors are rational as they think about the risk-return trade off as CAPM describe, but they face an impossible task. The world never stands still and the info on hand is too complex.”

Ø In a non-stationary world, everybody gets it wrong – or gets it right only as a matter of luck.

Ø In Kurz’s Theory of Rational Beliefs:

n Endogenous volatility: volatility that arises from surprise & stems from the forecasting errors at the very heart of the investment process (i.e., excess volatility in Shiller’s language).

n Exogenous volatility: volatility in the underlying fundamentals, such as earnings, dividends, and interest rates.

Ø Both Shiller and Kurz agree that endogenous volatility is about three times as great as exogenous volatility.

Ø Shiller’s studies of volatility conclude that: The EMH wins half the game, the proponents of behaviorally motivated markets win the other half.

Ø Paul Samuelson: “Modern markets show considerable micro efficiency (for the reason that the minority who spot minor aberrations from micro theory can make money from those occurrences and, in doing so, they tend to wipe out any persistent inefficiencies). In no contraction to the previous sentence, I had hypothesized considerable macro inefficiency, in the sense of long waves in the time series of aggregate indexes of security prices below and above various definitions of fundamental values.”

Ø Implication of excess volatility: the swings in stock prices seem to reflect investors’ attention to many factors other than the PV of the future stream of dividend payments: fads and fashions, fears and hopes, rumors and restlessness, recent stock price performance, or old saws about how in the long run everything comes out rosy in the stock market.

Ø Shiller: “The broadly based failures in thinking are not wholly attributable to… capriciousness of investors. Instead, these failures reflect lack of systematic attention and automatic reliance on popular or intuitive models.”

Ø John Maynard Keynes:

n Even if all the available info is in fact available, a rational forecast is so complex that many investors make their judgments on the basis of what they think other investors’ judgments are likely to be.

n This explains why LT investors are so scarce.

n When you know only a little, and you know you know only a little, it is tempting to believe others may know more, especially when markets are moving strongly in one direction or another.

Ø Shiller: “Capital Ideas are powerful, but people who do theoretical work in finance who don’t think of those applications. In carrying the theory too far, they miss the broader picture. The world they have constructed is not the world we live in. They either do not know the limitations of the theory or they are not interested in trying to fix those limitations.”