The Case Against Overstocking

A Yale economic professor posits that the equities markets are overrated and explores some radical alternatives.

Robert Shiller, professor of economics at Yale, is something of a Wall Street heretic. In his best-selling book Irrational Exuberance, Shiller argued that society is obsessed with the stock market and that this obsession fuels excessive volatility. In essence, the stock market creates “naturally occurring Ponzi processes” that draw in the masses of individual investors at the worst possible moment. When the inevitable break happens, stocks tend to languish, producing mediocre returns for years. Shiller argues that investors should focus on their “ordinary riches,” their homes and their careers. It is these ordinary assets, Shiller argues here and in his new book, The New Financial Order, that are increasingly exposed to the fast-moving global economy. Read on for Shiller's ideas on how to help society hedge against the large macro forces that affect a person's “ordinary” wealth.

Registered Rep.: Do stocks always go up in the long run?

Shiller: I think that people have been overly impressed with the record of stocks. The 21st century is a new century; it's going to be different from the 20th century, as different from the 20th century as the 20th was from the 19th. And just look how enormous that difference was.

People talk about the equity premium puzzle in finance — that the stock market has so outperformed other investments. I think that the puzzle has an easy answer. It shouldn't. It shouldn't outperform other investments, and it probably won't continue to do that.

Registered Rep.: Why?

Shiller: Because there's no reason. It was lucky. It was a lucky time for stocks.

Registered Rep.: So what to do?

Shiller: Well, the obvious thing to do is to diversify.

Registered Rep.: Diversify into what?

Shiller: The main asset categories are stocks, bonds, cash and real estate. But I also want to have the macro markets as an asset class that can be hedged. Take Goldman Sachs and Deutsche Bank. They helped create the economic derivatives market. Again, it's not a retail market, but my firm, Macro Securities Research, we want to make it one. I have the financial patent for macro securities that I've been trying to get some stock exchange or investment banks to offer. If we could create these securities, then it would be easy for retail customers to take positions in all sorts of things that they can't now. Like single family homes all over the world, incomes by occupation, incomes by country.

Registered Rep.: How would it work?

Shiller: Our idea of macro securities are bit like ETFs — they're index based, or based on some number, like GDP. So that there's no ownership of stock. So we issue them in pairs. Like talk about New York City — there would be — we have a long and a short macro security. A long macro security would pay a dividend that's proportional to prices of single family homes in New York City. And the short macro security would pay a dividend that moves opposite the prices of homes in New York City. And so one would move with housing and one would move against it.

Registered Rep.: So, if you own an apartment in, say, New York City, you can't hedge that position.

Shiller: You can't. But ours is one way of doing it. The other way I think will appear soon. In London, they know have futures markets for single family homes. But that's not a very retail friendly contract. Ours is retail-friendly in the sense that, although it does require that you have some other wealth. But for people who have a home and something else, they can put this something else into these securities, which will then tend to move opposite their home price.

Registered Rep.: Who would sell these, the advisor?

Shiller: Yes, right. You'd sit with your client, and you'd explain it to him as a kind of insurance. So a guy's thinking about his mortgage, and his insurance, his homeowners insurance. You could say, well, you can also protect against price risk by putting some of your portfolio into short New York macro securities. And why not? I would do it. It should be an easy sell. And they pay a dividend, but the dividend moves opposite home prices.

Registered Rep.: So meaning that if the home prices rise…?

Shiller: Then the dividend goes down, and presumably the whole price of the security goes down.

Registered Rep.: But then again, it's mitigated because the value of your real estate has gone up.

Shiller: That's right. So that's hedging. But, unfortunately, these macro securities don't exist right now. We're working on that. The other thing is home equity insurance — and those hardly exist, although there are various experiments with them. Notably, Syracuse, N.Y., in connection with some of my colleagues here at Yale, started a home equity insurance program last year where you can literally insure to protect the value of your home.

You make one upfront payment equal to 1.5 percent of the value of the house — again, it's the only payment you make. And then they pay you if you sell the house for any loss below the purchase price. Oh, here's the critical component: the selling price is not the actual selling price of your property, but is measured by a Syracuse Housing Price Index. This is what I advocated in my book and elsewhere. By using an index, you solve the moral hazard problem. If you settled it based on the homeowner's selling price, there'd be lots of ways for him to cheat — or just neglect the house, and it'd be a bad incentive.

So this thing, it's very clean. It'll pay the whole loss. If housing prices in Syracuse fall by 20 percent, then they will pay you 20 percent of your purchase price.

Registered Rep.: Who's they?

Shiller: Well, right now it's the City of Syracuse, the Neighborhood Reinvestment Corporation, which is a non-profit, and the federal government which has subsidized this. So the question is — it is a big question — is this going to be a viable business for private insurance companies?

Registered Rep.: In your newest book, The New Financial Order, you offer interesting ideas for hedging what you call ordinary wealth. You've just spoken about one of them. You also talk about employment risks and other kinds of other financial risks. Would you please step back and describe what you are trying to do?

Shiller: What I want to do is democratize finance. You have all these sophisticated strategies available for the wealthy and institutions and you even have sophisticated incentives for executives; I want to bring the same techniques to the population at large. So it's not just executives who have hedging strategies. Even working class people are launching some kind of small enterprise.

People recognize that there has to be a carrot, otherwise people won't work hard. There has to be something that excites them as a good outcome. On the other hand, people won't take risks if the downside is too severe. So you have to design things around people's psychology. And so I think what we saw developing, the better incentive systems, is really a very important step in insuring better economic progress.

Registered Rep.: What's an individual's biggest risk that you're trying to help hedge?

Shiller: The really important risk that people face is that their career dries up. Let's say you start out as an equity analyst. And you get your MBA and you train yourself, and then you reach the age of 35 and you're doing just great. And then suddenly analysts are in ill repute and the government is regulating them. So, suddenly it's just not paying well at all, and people are getting fired left and right.

So, you get laid off, and then you go looking around for a job, and you kind of realize that you're washed up — it's over. And you can try something else, but you won't have this great career that you thought you were going to have. You're now 40 years old, and starting to look like damaged goods on the labor market. And there are stories like this where people had a great decade and then headed south. So that's the really important lifetime risk that can strike very hard, especially in a changing economy. And I think that the economy is changing very fast, particularly because of new information technology, which has all sorts of repercussions.

Registered Rep.: So then — so you propose to have a livelihood insurance then that would protect against…?

Shiller: That's right. It would be something you could buy when you were young, and it would be offered in many different fields. You could buy insurance. A dentist could buy insurance against the dental industry being hit by some new technology that could severely diminish income or even renders dentists obsolete. It wouldn't require that he stay a dentist in order to collect, because that would be counterproductive. But he might have lost the value of years of training.

And the other side of it is, as I emphasized in the book, that if such policies were available, then there would be much more interest in specialized training, and there would be more willingness of people to specialize in their careers narrowly. When you look at businesses, there are lots of businesses you could start that have big upside potential, but only a one-in-five chance of even succeeding. That's not a very attractive gamble for an individual — unless you can get someone to share the downside risk with you.

Registered Rep.: If such a thing existed, brokers would have jumped all over it a few years ago. Remember when the retail broker was going to die, he wasn't needed anymore? All you had to do was go online. You could make the trade yourself.

Shiller: I think that idea has been tarnished. I think now retail investors are probably thinking, “I just want to have a real person that I can trust. I can't see dealing with this computer that might just lose everything for me.”

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