I was recently caught by a friend who discovered I was talking to myself while I thought I was alone – lost in thought. In my absent-minded ‘debate’ with an invisible counter party, I was explaining my rationale for employing specialty products designed to capitalize on the lessons of Prospect Theory. Indeed, so complete was my immersion in this ‘debate’ with an imaginary would-be critic that I even uttered the words “Prospect Theory in action…” out loud. The reason I was so preoccupied is that some people that I would ordinarily describe as intellectual allies had taken to attacking my choice of portfolio management tactics.
Later that week, this debate moved a little more into the open when an erstwhile intellectual ally offered an endorsement of support to someone who is less of an intellectual ally. Basically, I now had ‘friends’ who were siding with my ‘enemies’. I felt I had been let down – perhaps even modestly betrayed. I felt I had no choice but to approach my ‘friend’ to ask what was going on. We had a healthy and, in my view, productive and respectful exchange of thought on the subject. At issue is the interplay of economic concepts pioneered by Nobel Laureates Daniel Kahneman (2002), Eugene Fama and Robert Shiller (both in 2013). My strategy was predicated on Kahneman’s work on Prospect Theory – the notion that people experience losses twice as acutely as they experience gains. As far as I can tell, my friend and I agree on Kahneman’s work.
Moving on to the other guys, things get murkier. Since a company based on Fama’s research came to Canada in 2003, my friend and I had long been ardent supporters. Fama’s reputation is based on the notion that markets are highly efficient and that, save for tilts that might be incorporated to capture certain factors (such as value versus growth or small company stocks versus large ones), it is a fool’s errand to try to ‘beat’ the market through traditional trading and security selection. My friend and I agree on that, too, as far as I can tell – although some may say that the paragraph below ultimately contradicts that.
Robert Shiller has pioneered work on asset bubbles. Specifically, when valuations get really high, the expected (and ultimately realized) returns over the ensuing decade are modest. Conversely, when valuations are low, the returns over the next decade are high. This is essentially just a demonstration of what statisticians might call reversion to the mean. Shiller openly acknowledges that his work (most notably Cyclically Adjusted Price Earnings ratios – CAPE for short) are lousy market timing tools, but highly reliable in setting return expectations over the next decade.
The questions that this dichotomy often begs are: do Shiller and Fama flat-out contradict one another? Are their views mutually exclusive or is there some way or certain circumstance where both might be right? If these seemingly contracting views can be reconciled, how might we go about doing so?
In the interest of full disclosure, I want to state that I have deep respect for all Nobel Prize winners. These people are giants and we are all privileged to learn from them and to apply their teachings. I am but a humble practitioner advisor. Still, as a person who respects science and evidence, I feel it would be arrogant to take sides. People who respect evidence, science, truth and logic should park their tribalism at the door. In short, I do not believe it is responsible to be a “Disciple of Fama” or a “Disciple of Shiller” if one simultaneously purports to be a disciple of evidence.
My friend seems to disagree. He told me that: “Shiller’s work has been and continues to be contested. The academic debate on predictability is far from settled, but from a practitioner’s perspective, I believe that we should ignore CAPE altogether. This may seem extreme, but my thinking has evolved on this over the past year after an extensive review of the literature.”
To be sure, my friend did indeed do an extensive review. I was shown the evidence in question. My simple rejoinder is that Nobel Prizes are not handed out for people who fail to show their work. In essence, my friend and I disagreed on how Shiller’s teachings should be applied and he was critical of me for using them. He went on to say that the products I was using: “…seem to be contrary to what I would imagine you to say…..” and that “that is probably more my issue than yours.” Ultimately, that is where we diverge.
To me, despite the review, the highlighted statements above are open acknowledgements of Confirmation Bias. Confirmation Bias is the tendency to search for, interpret, favor, and recall information in a way that confirms or supports one’s prior beliefs or values. Being a longstanding “Disciple of Fama” is no reason to minimize and/or criticize the legitimate perspectives of those who are disciples of Shiller and Kahneman… no matter how much literature you review… and especially if the person you are criticizing is also a “Disciple of Fama”. There is no continuum of legitimacy for Nobel prizes. In trying to do the best I can for my clients, I am determined to follow the evidence, not to take sides.