By Robert Shiller
There are no easy answers in investing. It is tempting to replicate a successful strategy — one created by an outstanding investor, like Warren Buffett, or through in-depth statistical analysis of the wisdom of crowds — and such approaches can actually work for long periods.
But paint-by-number portfolios won’t succeed forever. And without deep expertise, it makes little sense to veer much from a simple market portfolio — one that seeks to match the overall performance of the market, and not beat it.
These reflections are prompted by the television series Genius (based on the Walter Isaacson biography Einstein: His Life and Universe), which I’ve been watching on National Geographic TV. The series also inspired me to reread Einstein’s own popularization of his theories, in the book Relativity: The Special and General Theory.
Albert Einstein, who may have been the most famous person ever to be publicly identified as a genius, had a disrespectful attitude toward the dignitaries of the physics profession of his time, and a lonely and unique approach to science.
Yet great as Einstein’s theories were, others in the scientific community had been on the verge of discovering them when he came along. In fact, it is possible to argue that large numbers of collegial scholars who do not keep secrets, do not pretend to know everything, and share freely will eventually surpass the achievements of a lone genius.
Similar debates dominate professional investing. For help in making important financial decisions, some of us are looking for Einsteins, others for communities of scholars or professional money managers with solid ideas.
In terms of popular reputation, Mr. Buffett may be investing’s closest approximation of an Einstein. Some investors have done well simply by copying Mr. Buffett’s financial moves.
On the other hand, many investors embrace the catchy methods that bubble up from time to time, like “smart beta,” a phrase for a form of systematic investing that claims to outperform the market. There is no universal agreement on what smart beta means, but it typically refers to published theories and replicable statistical analysis, and mechanical procedures aimed at beating them. Smart beta clearly is the epitome of community property, not quirky genius.
A lone investor, whether a genius or not, can typically keep a secret better than a community can, and does not have to publish his methods. This difference is important but not absolute, because the Securities and Exchange Commission generally requires large institutional investment managers to file quarterly reports listing their holdings.
Through the years, despite Mr. Buffett’s admonitions not to do so, many people have tried to mirror his strategy as it is revealed on the Berkshire Hathaway Form 13F filed with the SEC. Because Mr. Buffett presents himself as a long-term value investor, investors may think it doesn’t matter that this filing may be months out of date. But not understanding exactly how he makes decisions, they don’t have his edge, must come to the party late, and have frequently bid up prices as they compete against one another to buy the assets in his portfolio.
There is plenty of evidence of this: A 2008 study by Gerald S. Martin of American University and John Puthenpurackal of the University of Nevada, Las Vegas, found that when SEC filings reveal changes in the Berkshire Hathaway portfolio, the stock prices of newly acquired companies had an abnormal one-day increase averaging 4%. Even so, they found long-lasting effects. A simulated replication strategy from 1976 through 2006 based on the SEC filings outperformed the market by over 10% a year.
That was an amazing result, though merely copying Mr. Buffett has been less satisfying in recent years because his investment performance has dimmed somewhat. No one can excel all the time, and even a Buffett may produce in a lifetime no more than a few great ideas that may not be viable forever.
There are even bigger problems in replicating strategies extracted from the community of scholars who publish not only what they do, but why they do it.
For example, a much-talked-about paper by R. David McLean of Georgetown University and Jeffrey Pontiff of Boston College published last year pointed out that the effectiveness of stock market investing strategies seems to diminish, but not disappear, after publication.
The paper, which won the American Finance Association’s 2016 Amundi Smith Breeden Award, examined 97 financial patterns that appeared to predict investing returns, and had been published in reputable scholarly journals and supported by tests that found statistical significance. Such strategies relied on factors like price-earnings ratios, changes in analyst recommendations, credit rating downgrades, stock price momentum, industry momentum and failure to pay dividends.
The researchers looked at the performance of each of these strategies, assuming you had started right after publication of research papers on them and then continued for years. They found that while the strategies outperformed the market, their success decreased by more than 50 percent after publication.
In a follow-up paper, the two authors, along with Joseph Engelberg of the University of California, San Diego, showed that one-day positive surprises on firms’ earnings announcements accounted for nearly all of the investment’s total outperformance. Why? It appears to be because the market consistently makes mistaken valuations of corporate earnings, which tend to be corrected in stock prices only when the final earnings evidence is staring traders in the face.
So what’s an investor to do? Both published statistical analyses and published actions and opinions of knowledgeable people, whether geniuses or just smart and well-informed investors, are worth mulling over, if you have a taste for such things. But don’t follow these strategies blindly. We need to exercise our intuitive judgment as well as rely on the wisdom of smart, well-informed people to decide whether to continue to rely on statistical indicators, and investment strategies that seemed to work in the past.
The problem is that the world is too complex for any method to work all of the time. The economist Alfred Marshall, then of Cambridge University, wrote in his 1890 textbook Principles of Economics: “Although scientific machinery should be as definite as possible, at the same time it should be flexible.” He added, “There is so much variety in economic problems, economic causes are intermingled with others in so many different ways, that exact scientific reasoning will seldom bring us all the way to the conclusion for which we are seeking.”
His reasoning is still valid. We need to use statistical analysis but also respect human intuition and even genius, if we are able to identify it. But do so with caution. No single strategy is likely to beat the market forever.