Article published on 10/20/13 in Diario de Avisos by José Alberto León Alonso.
What determines the price of a stock? Can you predict their performance and behavior? The 2013 Nobel Prize in Economics awards Fama, Shiller and Hansen for trying to answer these questions and, in general, those related to predicting the future prices of any asset.
A market functions properly if the evolution of prices is not predictable. Otherwise, it could be predicted that a certain asset will see its value increase and investors would acquire it now with the aim of obtaining a future benefit. But these purchases would currently increase its price, making it unattractive. Thus, a market functions properly only when prices quickly assimilate any new information about the assets. In 1970, Eugene Fama, the first Nobel laureate, showed that predicting stock prices based on the previous day's price developments was not possible, as would be expected from a well-functioning stock market. He developed a theory around this idea and called it the Efficient Markets Hypothesis (in English Efficient Market Hypothesis, EMH). Share prices collect all available information, and all new information is reflected in prices immediately, so that they follow an erratic and unpredictable evolution. The corollary of this theory is that the best way to invest in the stock market is to do so in index funds, which diversify risk, and not in supposed professional managers, because you cannot beat the market since there are no reliable forecasts. According to this theory, a blindfolded monkey throwing darts at the financial pages of a newspaper could select a portfolio as good as the best experts and, as various experiments show, that is precisely what happens in reality. Burton Gordon experienced it in 1973 and the “monkey” portfolio outperformed 85% of the funds. The Wall Street Journal continued the experiment for 15 years and the randomly selected investment portfolio outperformed 61% of the funds.
For the next forty years, scholars have dedicated themselves to analyzing the EMH to determine its validity to conclude that in the short term there is no predictability possible, so it is possible to affirm that markets are efficient, but in the long term the same does not occur. This hypothesis does not explain the formation of bubbles. In the 1980s, Shiller, the second Nobel laureate, showed that you can establish a simple investment rule with which you are very likely to make money. Thus, an investor who sells those of his shares in which the ratio resulting from dividing their value (discounted their risk) by their dividends is high, and buys others in which this ratio is low will outperform the market, because the shares whose price has grown a lot this year are likely not to do so as much in the coming years, since share prices fluctuate much more than is rational. If so, why don't long-term investors invest in cheap securities just as they do in the short term and drive up their price?
The answer is that investors behave irrationally during bubbles and depressions in the business cycle, following behavior in flock or herd. For Shiller, people's investment decisions respond more to emotional or intuitive factors than to rational behavior. Shiller claimed to be able to detect bubbles or undervalued values, contradicting the hypothesis of market efficiency, which would respond to collective psychology, where trust or fear would play a fundamental role in setting prices, giving rise to cyclical fluctuations beyond what is rational. Shiller said that the EMH assumed that everyone was brilliant and efficient all the time, and that was not true. Sometimes investors experience periods of “irrational exuberance,” which explains bubbles. Precisely in his book “Irrational Exuberance”, published in 2000, Shiller detected signs that housing prices in the United States had grown above what they should have, which would end up being corrected over time. And he was right. Psychological biases such as the fact that people remember recent prices more than old ones are the fuel for housing bubbles. That is why such absurd thoughts are spread as that “housing prices are not going down” and properties are bought at any price, no matter how high.
Many things happen between the short and long term that are not irrelevant and are flooded with uncertainty, circumstances for which the valuation models of Hansen, the third winner, are of unquestionable value. His models, simpler than the dominant ones up to that time but as effective or more than these, have demonstrated the veracity of Shiller's conclusions and provide the essential statistical equipment to verify the plausibility of these and other theories.
What conclusions can the small investor draw from all this? In 2006, Nitzsche, Cuthbertson and O'Sullivan compiled the existing literature on the profitability of investment funds in the United States and England, and concluded that less than 5% of equity investment funds outperformed stock market indices, and that active management did not appear to improve fund profitability. So the corollary of Fama's theory, “invest in index funds,” seems like a good recommendation for the small investor. There are few who beat the market consistently, although it is evident that there are people with a special ability to do so. What happens is that these people are dedicated to large assets. Warren Buffett, a skilled investor whose success has made him a billionaire, once said that "when the ignorant investor recognizes his limitations, and acts accordingly by indexing his investments, he is no longer ignorant." So for the small investor, there is no doubt. Whatever the bank's financial advisor says about the latest miraculous financial product, you shouldn't listen to him. Diversify your risk by investing in exchange-traded funds (ETFs) that replicate stock market indices (IBEX35, Eurostock, DAX, S&P, etc.) and the one with the lowest commissions. By applying a long-term passive management strategy and accepting that the profitability will be what the market gives, you will do better than 95% of expert managers. That is as long as there are no episodes of irrational exuberance, because bubbles like meigas "there are some", so if you detect any using Shiller's methodology... sell!
