[Andrew Lo] Hello I'm Andrew Lo and welcome
to In Pursuit of the Perfect Portfolio. Today I'm honored to welcome Robert J. Shiller
Stirling Professor of Economics at Yale University and the winner of the 2013 Nobel Prize
in Economics. Bob thank you very much for joining us today. [Bob Shiller] My pleasure. [Andrew Lo]
So Bob I want to start by talking a bit about your background. How did you choose economics? What
was the decision-making process when you have made the choice to come to MIT for graduate school.
[Bob Shiller] Well when I was young I thought everything sounded interesting and I thought it
was a great tragedy that I had to narrow down to one thing economics. You know it was Samuelson
here at MIT who got me into economics. When I was about 14 years old my brother came home from
college with Samuelson's Economic and I read it. So maybe economics sounded like a field that
brings things together you can do mathematics, or physics analogies and then there are people
in history. So I guess I had to make a decision I picked economics. [Andrew Lo] Right well that's
terrific and you came to MIT of course and your thesis was actually on rational expectations
models it was actually pretty technical wasn't it? [Bob Shiller] Yeah also distributive lags
yeah econometrics appealed to me and modeling appealed to me. [Andrew Lo] And it was one of the
first research articles that were really focused on the econometrics of rational expectations.
[Bob Shiller] I was here and I was interested in robustness. You know I didn't really
believe, no one really believes these models, right they're always wrong. But I wanted to
get at the insights from it and I thought I was thinking about that and thinking about how to
quantify things and it got me into fundamentals of probability theory and Bayesian econometrics.
[Andrew Lo] So you got to understand the irony then when we now turn to your research on
behavioral economics and finance because a lot of the early work that you did was actually
quite important for developing the foundations of rational expectations econometrics. So at some
point you decided to focus on alternatives to the rational expectations, right? How did that
come about it? Was it a long process or short process? [Bob Shiller] Well I've always been
interested in people when I go to sports events, which is rarely, I find myself watching the crowd
rather than the game I don't care who wins this. I don't know maybe it's me something missing in
my motivational structure but I'm just fascinated by people. [Andrew Lo] And so in thinking about
people obviously macroeconomics is another field that you've made a number of contributions in
that's obviously a very important area because you're looking at the aggregate behavior of lots
of people interacting. How did you get interested in that from rational expectations to focusing on
macroeconomics? [Bob Shiller] Well it's hard to describe how one got interested in anything. I was
influenced by particularly by, Franco Modigliani, my professor here who I don't know he was just
a connected person who did quantitative work and also cared about what was happening in
the world and knew about those things and but it wasn't any one specific person you
know .I think it's also partly random I could have gone into medicine, into physics and it doesn't.
Academia is a nice environment, unfortunately, a little bit competitive and sometimes stressful
but you could you agree right any of these departments there's interesting work to
do. [Andrew Lo] Well we're happy you what at the economics and finance and along those lines one of the things
that you pioneered was real estate indexes I mean like the case-shiller index azar now used all over
the world to try to understand real estate markets when you started working that area that wasn't
a particularly popular area for a car working is that right so here's one of my observations
about people they run and herd and they did people do the same and in the short run that might even
be the optimal strategy if you're a young person trying to get ahead you have to go to conferences
for example if that means you have to get immersed in what other people are doing yeah but I also
think that people miss things you know the big opportunities are not in advancing the current
dialog but it's mind looking at something that nobody else is doing and in this case I think real
estate was under researched in business schools and when I worked with Carl case here there
wasn't any in the serious index of home prices in there were some and then one didn't go very far
back it's like nobody cares how can nobody care about we all buy houses we well at that moment it
focuses your mind and you think what's the market going to do but I thought I I would just do it and
by the way I didn't I didn't push to get it into a top journal the I thought these specialty journals
are some of the most interesting places and not the most prestigious but real estate economics
was a specialty like that I don't think it had the highest status in in the profession and
it wasn't attracting enough interest well you certainly elevated that with your indexes and then
a number of papers that you published afterwards in fact so you've now managed to call two bubbles
pretty early on one was of course the tech bubble that you had talked about the fact that the market
was overvalued but then after the bubble burst you continued and talked about the real estate bubble
so the whole irrational exuberance period the phrase that you coined can you tell us about
that particular your faithful lunch with Alan green because he took that idea he made yeah I'm
not sure who coined it actually it goes back a hundred years uh-huh but Alan Greenspan made
it famous and maybe I helped a little so tell us about that fateful lunch well I was invited
with John Campbell my co-author who testified before the Federal Reserve Board in 1996 and this
focuses your mind here we're getting a hearing from a very powerful body and John Campbell and I
decided to describe what was going on as a bubble little early because the market didn't peak until
four years later a three and a half years later and we had lunch with said board members including
Alan Greenspan I we told them hey this isn't rash this is psychology and two days later Greenspan
came out with a speech in which he used the word irrational exuberance now how did you come to that
conclusion because that's a pretty stark contrast to what many other people were saying at the same
time well it's kind of like I just mentioned that I used to go to sporting events and watch the
crowd instead of the game the crowd is so much more interesting yeah why do they care why do they
get all you can knowledge you can see their body language when someone's making a difficult move
in there they almost feel that they're doing it it's empathy yeah so what were you seeing in 1996
in the crowd well I thought that there was it was so obvious to me I played a game with my wife only
how to eat I said now I'm not going to listen to other peoples conversation but I can have a
billet II to hear the word stock market okay and every time from adjacent table yes every time
we went out to eat I'd hear stock market it's it's uncanny how the spirit of the times changes right
and suddenly everyone's excited about some based it on that okay that's that kind of observation
but you also measured things like p/e ratios right other kinds of analytics what were the analytics
telling you at the time well I had a ratio or John Campbell and I had a ratio that we now call
a cape or cyclically adjusted price earning it's just a price earnings ratio where the denial Nader
is smooth the earnings is smoothed over ten five or ten what we're usually ten years that's because
earnings are very volatile from year to year it's the basic idea of just the price earnings ratio
yeah and we saw that getting into record high levels so we looked historically at what does that
for ten well there aren't many examples that's the problem with history there aren't enough examples
of these extraordinary circumstances but what what happened when the ratio gets high price over
earning what changes to bring it back is it the the earnings go up or the prices to go down like
we found that historically it was the prices go down so it was a model of human psychology that
just sometimes everything looks great you know we're all excited yeah and it's best to stay away
from crowds that are overly excited about anything well so just to with play history 1996 was really
the beginning of the internet bubble developing I mean it hadn't peaked anywhere close to where it
ended up in 2000 when it started coming down so you were quite early what would the reactions of
your colleagues and people in industry at the time was there a fair bit of acceptance skepticism
well there is an enormous skepticism yeah like you are embarrassing our academic community we
have solid econometric evidence that markets are efficient what are you talking about that's
the reaction it was it was angry and it was that there's a conventional with a received wisdom
and information but actually if you look at the data it's one of these people have the impression
that there's all this evidence supporting market efficiency we look at the literature even the
literature in 1996 there were lots of anomalies being reported right that's right so in retrospect
then after the internet bubble burst did you find more acceptance of your ideas or is there still
resistance because you have a second bubble that we're gonna get to in a minute yes a very big
one I think that the econ profession has always had a 10 between the rational quantitative types
and the they're still quantitative maybe but the psychological type it's kind of people have tastes
in these things and but unfortunately choosing one or the other seems to involve a worldview in a
self view so people who are very in love with efficient markets tend to apprise themselves
on their rationality also and have you ever been involved in an open debate with you know a
gene fama oh yeah well you mentioned gene fama I had a whole week debating there's something
called Nobel week after a Nobel Prize yes and you know the thing that struck me first I like
the guy I'm very impressed with him sure but we don't really disagree much on the fact it's all
down into interpretations yeah so you know what it seems like he wants to when he's famous for
identifying anomalies but but he likes to come up with the idea that how do you know it's not
rational you know for example crazy dictators in history how they rational but it looked crazy to
me but you know it's an act you know they really are doing this it's a political game they're
playing they're really smart people crazy vs. crazy like a fox that's right okay so then in
terms of the second bubble that was developing so now we're talking about the period between
2002 and 2008 where real estate starts going up and starting around 2006 according to the Case
Shiller index the peak of the real estate market in the United States hits what were you saying
and what were you thinking during that period of time because I know you were making statements
public right about the high value real estate well one thing I did is create a home price index back
to 1890 nobody had one right you just look at the picture anyone I show the picture Wow look what's
happening right now yeah it looks anomalous then the question is what to make of it if something
is unusual and is it interest rate or is it is it's a some policy of taxes or population growth
so I work with chip Kate Carla case on this we couldn't seem to find anything like that there's
nothing plausible except bubble oh now that was a still a contentious word and even in 2013 and
during no bail week when I said the word bubble I could I could see Eugene fama squirming he doesn't
like that he said call it that nefarious term and he said it's never even been properly defined what
it even is so but I first it's often used careless there are certain terms that are used more by the
press the newspapers are an academic and often carelessly use but I think there's an element of
truth there are bubbles there are times of popular excitement right people see prices going up in
some market they get excited smart money stays out and sometimes they short but as we know the
short sales are sometimes not enough especially in housing you can't change out a house yeah right
also you're according to your home price index I looked at the series going back to 1890s it's a
fantastic research tool and it's a real home price index you adjust for inflation so you compare
apples to apples across time and the amazing thing is between 1996 and 2006 home prices nearly
doubled it was connected right and much higher than over the course of the last five decades and
so when that was going on what were you doing in terms of speaking to the press because I know you
made a number of public statements about hams what were you doing in and how is it received well
you know I was still a little bit diffident I was writing a newspaper column but I didn't really
know either you know history is is inscrutable and nobody has perfect market timing so you can't time
these things but I have an academic attitude that I don't want to make statements that I can't
support on the other hand when I'm writing a newspaper column it's a little bit different sure
people want to know what you're thinking and as long as you don't oversell you can tell people
what you're thinking so again once again it was similar it seemed obvious I would I was visiting
Phoenix which had rapidly it was a little bit late to the bubble but then prices were really sorry
and I mentioned to my cab driver from the airport what's going on in home prices boy did that set
him a hostage he was kind of dark and dark and dark find out different houses what they sold for
so this is your restaurant tests all over the same things that are talking about real estate yeah so
now the real estate bubble has burst in 2008 nine we have the financial crisis any observations
post-mortem in terms of what happened and what we might do to prevent these kinds of things from
happening again or is it just inevitable well some of it is inevitable because people are people and
also they may not be the end of the world we don't want the remedy to be worse than the issue so you
know people are excited by bubbles and to some extent this excitement about investing does lead
to good outcomes maybe it doesn't have to come all at once you know it can doesn't have to be
gradual so it's a human phenomenon that you know the countries that have the biggest bubbles and
bursts are some of the most successful countries on the other hand we don't really want people to
get caught in them and have their lives disrupted so what I often say is get a financial advisor
and get one that good people recommend right they generally are helpful well so now that brings
me to the main subject of our interview which is the perfect portfolio can you tell us a little bit
about your perspective on the portfolio management industry to begin with and then I'm going to turn
and ask you to tell us a little bit about what you think the perfect portfolio is for the typical
investor well okay when you say perfect portfolio it brings me back to some mathematic the capital
asset pricing model and you can define out now some people would say that perfect portfolio
is the same as the market portfolio because if everybody is doing that but then it is the same
right but I think that's where the capital asset pricing model is being overextended not everyone
is doing that right you have to make some sense not many people are very quantitative about
you have to invert a matrix that sort of thing I guess and we don't know the future is still
a little fuzzy yeah so I guess what it has to be a widely diversified portfolio I think people
are too afraid of investing abroad generally or across major asset classes and also I would say
it has to deal with your own vulnerabilities if you work in the automotive industry you shouldn't
put a lot into automotive stocks you might want to short them how do anyone does that so I I think
also that the perfect portfolio would involve some financial innovations for example I have been
advocating for years now that government issued GDP linked bonds has that worked well the simplest
GDP linked bond might work with mark chemstro at York University is what we call it trill it's
just a share in GDP one a trail is one trillions of the country's GDP okay so if the GDP of the
US is eighteen trillion then this year you get $18 dividend on one chair let's see and that just
goes forever paid in local currency but see if you handle it if you if you have it would benefit both
investors and and and government governments would be putting them into a less leveraged position
instead of bowing at a fixed rate they would be borrowing like equity you know it would be
bowing in such a way that their tax revenues would correspond to their obligations and for investors
it would be a much more wide diversifying mood the move the GDP is much bigger than corporate profits
it's typically ten times bigger right for each country and so investing in GDP is a much broader
diversification and investing in stocks so this is very much along the lines of your general theme on
macro markets trying to create riders that don't yet exist and from an economic perspective that
makes total sense because you're completing the market and allowing people to hedge has not gotten
any traction from the folks that could actually implement these ideas well the interesting news
may be coming soon I hope the g20 nations in what in the Turkish year they were talking about the
air demboski of the central bank of Turkey was interested in GDP linked by but I don't think
it made it into the g20 statement next year it's Germany and I was at a g20 conference and I was
talking it up so are other people Mark Carney at the Bank of England is interested in them it was a
great idea to be able to hedge these kind of risks otherwise there's no other way for individuals to
deal with things like business cycle downturns and recessions and so on and these things happens they
happen slowly financial innovation is slower than the fastest innovation is in these mobile phones
or acts technology man we get them right away and it's fun the problem with investing innovation
is that you don't see the outcome right away and people are mistrustful of financial innovation
well so I want to close Bob with one final topic to talk about your work on markets and the good
society tell us a little about your perspective and what you're working on now you're good society
is an old phrase referring to I like to define there's just nice people okay financiers often
don't seem sometimes they don't seem like nice people but they really are and really candy so the
good society is a society that encourages human development and freedom and good health and all
these nice things how do we get that I still you know despite all my interest in human behavior
think that a free-market democratic system it's not not totally unregulated free market but with
a civil society that oversees regulation is is a good thing sorry I've written yeah also with
the a Karratha I've written about a vision for society but it's not really our vision it's
just emphasizing what's happened in in the past and financial innovation is part of it it's
absolutely a part of it what people face risks in their lives and how do we in fact really deal
with that it's it has to be a contractual some form with either insurance or hedging and it it
makes our life are civil and also entrepreneurship is something that won't happen unless we have
financial arrangements to support it you know well thanks to the research that you've done
with your co-authors we have a little bit closer to that goods recited them before thank you very
much for joining us today Bob pleasure my pleasure you
