Eugene Fama’s work paved the way for the creation of a product that would simply mirror market performance (the index fund).
Robert Shiller’s work gave us a clearer understanding of how investors behave in reality.
When the Nobel committee announced last month that Eugene Fama and Robert Shiller would share this year’s prize for economics, it was a great moment for their research in the field of investing—and validation for Betterment, which relies on many of their insights.
Although Fama and Shiller are often cast as rivals, with dueling viewpoints on markets and investor behavior, their work in fact supports the emergence of investing models that can boost the returns of ordinary investors by controlling for both market randomness and investor emotion.
In fact, Betterment stands as a synthesis of these two Nobel-winning theories. Fama’s taught us how to select investments and build portfolios, and Shiller helped us understand how to build a more rational investing service.
We did a little genetic mapping to show how important strains of both men’s work can be found in Betterment’s DNA today.
A very short history of (not) beating the market
From the earliest days of the earliest stock markets, even hundreds of years ago (think: South Sea Bubble), the prevailing wisdom was that individual investors could, if they were smart enough, predict the movement of asset prices and profit from them—either by a careful analysis of a security’s past history, or by forecasting based on a close reading of a company’s fundamentals.
It would be a slight exaggeration to say all that changed in the 1960s, when Eugene Fama proposed his efficient markets hypothesis in a paper called, “Random Walks in Stock Prices”. But it wasn’t long before Fama’s insights about the unpredictability of market movements swayed many minds on and off Wall Street to believe that beating the market was a fool’s errand.
In effect, Fama said, securities’ prices are always immediately adjusting to new information (or even the expectation of new information), far faster and more accurately than any one individual investor could.
So, securities’ prices are not only independent (and random): they have no memory for what came before. The result is that future movements cannot be based on past or current movements. As he concludes: “A simple policy of buying and holding the security will be as good as any more complicated mechanical procedure for timing purchases and sales.”
Betterment draws heavily upon the insights of Fama and Shiller, and their disciples to create services which actually result in the highest net of fee (Fama) and net of mistakes (Shiller) return for clients. Enter the index fund
All of a sudden, average returns weren’t just acceptable—they were optimal.
Thanks to Fama’s work, the road was paved for the creation of a product that would simply mirror market performance (the index fund), and a new passive investing philosophy that was a stark contrast to the investing wisdom of the day. Gradually, index funds became a popular way for individuals to invest.
But that wasn’t all. As part of Fama’s work, he discovered additional market “risk factors” which influence the returns of portfolios. While Harry Markowitz’s original “Portfolio Selection” article in 1954 (which established modern portfolio theory) considered only a single market risk factor, Fama found there were other risk factors that could lead relative outperformance, including overweighting small-cap and value stocks.
These tilts came with their own independent sources of risk, and so offered the ability to achieve higher risk-adjusted returns through diversification.
As a result, Betterment’s portfolio includes both value and small-cap tilts.
Homo economicus bites the dust
But if Eugene Fama’s legacy has been the need to accept the aggregate wisdom of the markets, Shiller’s contribution was that the markets aren’t always right—because asset prices are also influenced by humans, who aren’t always rational actors.
Shiller’s best-selling book Irrational Exuberance (from a term coined by Alan Greenspan) documents that price movements are typically more dramatic than indicated by either news or company performance, and reflect the impact of investors’ often emotional choices.
In fact, while many credit Shiller with predicting the tech bubble of 2000, the subsequent housing bubble, and the financial crisis of 2008, Shiller’s most valuable contribution to modern investing may be his in-depth exploration of investor psychology, and how the unruly herd may simply run itself off a cliff.
Just as investing gospel once held that the right formula could predict price movements, for years people also subscribed to the idea of homo economicus—that people were rational financial beings, who would make rational choices in their own self-interest.
Controlling human emotion
Shiller was hardly the first to document that Man the Rational Actor was a myth. But identifying human emotion as an investor’s Achilles’ heel helped establish the field of behavioral economics (in addition to the work of great economic theorists like Richard Thaler and Daniel Kahneman).
Shiller’s work also gave us a clearer understanding of how investors behave in reality, and encouraged the use of products (like target-date funds) and policies (like auto-enrollment) to counterbalance certain innate human failings.
Put concisely—it’s actually much smarter to admit that you aren’t perfectly rational, and to plan and invest accordingly, rather than deny your true nature.
And then there was Betterment
So although Fama’s research and Shiller’s are certainly distinct, they actually provide two important pieces of the puzzle facing the modern investor.
How do you come out ahead in an investing climate where it’s all but impossible for ordinary investors to beat the market (Fama), and when there’s so much information available, that it’s tough not to succumb to your own emotional impulses (Shiller)?
Betterment draws heavily upon the insights of Fama and Shiller, and their disciples to create services designed for the highest net of fee (Fama) and net of mistakes (Shiller) returns for clients. And, thanks to the evolution of investing technology, we’re able to automate these basic principles in an efficient, online (increasingly mobile) package.
By helping customers achieve optimal expected returns, while minimizing the influence of emotion via automation, we’re proud to claim some of the theoretical DNA of these two great economists as part of our heritage.
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