3 Nobel-Winning Ideas Investors Can Use
We're now within three trading days of the Treasury's Oct. 17 deadline to lift the debt ceiling with no accord from Washington -- not even a temporary one that would push the deadline to next month. It's disappointing and nerve-racking that our elected officials haven't had the good sense, wherewithal, or even simple decency to settle this issue earlier.
Do I think a technical default will ultimately occur? No. Does waiting for the 11th hour raise my level of concern that a default could occur? Absolutely. Were we to default, "that would make the U.S. the first major Western government to default since Nazi Germany 80 years ago," according to Bloomberg -- hardly a flattering comparison.
The market may be feeling the same way this morning, as the S&P 500 and the narrower, price-weighted Dow Jones Industrial Average were down 0.53% each shortly after 10 a.m. EDT.
Investors: Back to the classroom!
It's Nobel season, and this year's Economics prize is directly relevant to all investors.
The Royal Swedish Academy attributed the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2013 (the formal name!) to three U.S. academics -- Eugene Fama and Lars Peter Hansen of the University of Chicago and Yale University's Robert Shiller -- for "the empirical analysis of asset prices." What does that mean in plain English? Here are three ideas they developed that will make anyone who understands them a better investor.
Beginning in the 1960s, Eugene Fama and several collaborators demonstrated that stock prices are extremely difficult to predict in the short run, and that new information is very quickly incorporated into prices. These findings ... changed market practice. The emergence of so-called index funds in stock markets all over the world is a prominent example.
Lesson: Because stock prices are essentially unpredictable in the short run, trading is a losing proposition. The odds aren't favorable to begin with -- they're roughly 50-50 - and that is before one considers with the costs associated with trading (bid-offer spread, slippage, and commissions). Index funds bought for the long term are much the better proposition, which brings us to the second idea rewarded by the Nobel committee:
If prices are nearly impossible to predict over days or weeks, then shouldn't they be even harder to predict over several years? The answer is no, as Robert Shiller discovered in the early 1980s. He found that stock prices fluctuate much more than corporate dividends, and that the ratio of prices to dividends tends to fall when it is high, and to increase when it is low.
Many so-called investors take a casino approach to the stock market, and Robert Shiller indeed showed that stock market volatility is higher than can be explained by changes in company fundamentals, which he modeled using corporate dividends. For genuine investors, the lesson is to ignore the "game" and instead use the stock market as a means to participate in the creation of long-term value by excellent businesses. "One approach interprets [Shiller's] findings in terms of the response by rational investors to uncertainty in prices," said the committee. "High future returns are then viewed as compensation for holding risky assets during unusually risky times."
Final lesson: Stock valuations tend to correct through mean-reversion -- that is, high valuations tend to fall and low valuations tend to rise. Investors ought to consider that periods of peak uncertainty, and thus stock price volatility, are likely to present the greatest long-term opportunity. One recent example of that type of opportunity comes courtesy of Berkshire Hathaway CEO Warren Buffett, who enjoined investors to "Buy American" in October 2008, with spectacular results for those who followed his advice.
Putting These Lessons to Work
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The article 3 Nobel-Winning Ideas Investors Can Use originally appeared on Fool.com.Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned; you can follow him on Twitter @longrunreturns. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.