(October 14, 2013) — Three prominent US-based academics have scooped this year’s Nobel Prize for economics for their work on predicting long-term trends in asset prices—and changing the investment landscape forever.
Eugene Fama and Lars Peter Hansen, both from the University of Chicago, and Robert Shiller from Yale University were formally awarded the prize this morning.
“Their methods have become standard tools in academic research, and their insights provide guidance for the development of theory as well as for professional investment practice,” the Royal Swedish Academy of Sciences—which awards the prize—said in the announcement. “Although we do not yet fully understand how asset prices are determined, the research of the laureates has revealed a number of important regularities that are helping us to arrive at better explanations.”
For roughly the last four decades, the dominant conventional wisdom has been that markets are efficient, predictably random, and self-regulating—a set of ideas generally associated with the University of Chicago, the home of Efficient Market Hypothesis (EMH) creator Fama and colleague Hansen.
The EMH rests on three basic assumptions: (1) Most investors are rational, and incorporate all known and relevant information into their decision-making—thus, the price of a security reflects its real “value”; (2) when investors are irrational, they trade randomly and cancel each other out; and (3) since only some investors are irrational, even if they do cause prices to go out of line, rational arbitrageurs will bet against them by purchasing under-priced assets and selling, or even short-selling, overpriced assets.
The EMH led to several important developments for investors, which aiCIO initially investigated in June 2011 in a piece dedicated to the theory: Reasons Why You’re Crazy.
The first and arguably most important of these developments was indexing: If markets are generally efficient, it is theoretically impossible for stock pickers to beat the market on a consistent, risk-adjusted basis.
Secondly, the EMH also propped up the arbitrage industry as the fastest and boldest arbitrageurs realised there were enormous profits to be found in temporary inefficiencies.
However, all theories have their critics. In May 2012, a leading group of investors claimed the EMH and capital asset pricing model (CAPM) led to the 2008 financial crisis and called for immediate action to prevent it from happening again.
A spokesman from the 300 Club of leading investors said: “Harry Markowitz, the pioneer of modern investment theory, was the first person to make risk the centerpiece of portfolio management. This view inspired the origin of the CAPM and EMH, both of which have since dominated portfolio theory. However, the evolution of these two theories led to the inference that markets are efficient and that active management does not work, which is simply untrue.”
Andrew Lo, professor at the MIT Sloan School of Management, added to the argument, saying that the EMH was not wrong, but incomplete. “Markets are well behaved most of the time, but like any other human invention, they are not infallible and they can break down from time to time for understandable and predictable reasons,” he wrote, urging investors to view financial markets and institutions from the perspective of evolutionary biology rather than physics.
Shiller’s basic philosophy contends that even if asset prices are difficult to predict in the short-term, they are set to follow a steady path over a longer time horizon. His research showed that large uplifts in stock prices are usually followed by sharp corrections, meaning equities track a central path, once the variations cancel each other out.
This pattern holds not only for stocks, but also for bonds and other assets, the Nobel Prize awarding body said.
One of Shiller’s most prominent followers is Andrew Ang, Ann F Kaplan Professor of Business and Chair of the Finance and Economics Division, Columbia Business School in New York. Ang told aiCIO in February that Shiller and MIT Professor Steven Ross “have changed theory and practice because they think in terms of the big picture and make themes easily relatable”.
For more information on the scientific basis for the prize from the Royal Swedish Academy for Sciences, click here. For easier reading on the reasons for the award by the panel, click here.
Related content: Unmasking the Chicago School, Reasons Why You’re Crazy—EMH and its Developments for Investors, aiCIO’s The Professors 2013