The Investment Scientist

Eugene Fama and Robert Shiller Win Nobel Econ Prize

Posted on: October 14, 2013


I jumped out of my chair in delight when I learned that Eugene Fama and Robert Shiller had won this year’s Nobel Prize in Economics. These are two economists that greatly influenced my investment philosophy and their works have been an integral part of how I help my clients build and preserve wealth.

Let me explain their contributions:

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Eugene Fama is the guy who discovered that the market is by and large efficient; there are three implications of this finding:

1. You can’t use information already in the news to beat the market. (Application: watching Jim Cramer show is a total waste of time. I personally rarely tune in into CNBC.)

2. Market timing and stock picking are at best unproductive. Application: (I never do these to my accounts and my clients’ account.)

3. Active fund managers who pick stocks and time market don’t add value, they only add costs. (Application: all of the money I managed are in low cost passive asset class funds or index funds.)

Now I am sure you can find exceptions to these. But exceptions prove the rule.

His most groundbreaking finding is that equity risk has three dimensions: market, size and valuation. To put it in practical term, if you invest in small cap and value stocks, you will earn higher expected returns. That’s why my clients’ investments are tilted towards small cap value.

Robert Shiller is most recognized for calling the two bubbles: the tech stock bubble in 2000 and the housing bubble in 2006. His most impactful (on me) research was on the relationship between stock price volatility and dividend volatility.

Think about it, when you pay a certain price to buy a stock, you are paying for a future stream of dividends, therefore prices shouldn’t be more volatile than dividends. But instead, he found stock prices are 15 times more volatile that dividends.

His insight guided my investment choices during the financial crisis when prices were dropping like a rock by 40% to 50%. I knew from historical precedent and his research that the earning potential of companies would drop only a small fraction and prices were bound to bounce back strongly. And they did.

Having this knowledge made it much easier psychologically to balance my clients money into beaten down stocks. When stocks bounced back, some of my clients got back to even in December of 2010, a full 2 and a half years earlier than the market.

Such is the power of knowledge and the use of investment science to build and preserve wealth.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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