The Economics Nobel Goes To: Eugene Fama, Lars Hansen and Robert Shiller

The economics Nobel goes to: Eugene Fama, Lars Hansen and Robert ... http://www.washingtonpost.com/blogs/wonkblog/wp/2013/10/14/the-...

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Email Print Reprints The economics Nobel goes to: Eugene

Comments Fama, Lars Hansen and Robert Shiller By Neil Irwin, Published: October 14 at 9:00 am E-mail the writer

Three Americans were awarded the Nobel prize in economics Monday for work that helped answer this crucial question: What determines the prices of an asset, whether a stock, bond or a house?

The winners of the $1.23 million prize were Eugene Fama and Lars Peter Hansen of the University of Chicago and Robert Shiller of Yale. Their work has led to everything from low-fee index mutual funds to a deeper understanding of why home prices can become irrationally high, as they did in the last decade.

Fama and Shiller are considered direct opposites in their views of how markets sort out the prices of financial assets. Fama, 74, is a father of the "efficient markets hypothesis," the idea that because markets are very good at incorporating all known information about the value of an asset, it can be a fool's errand to try to predict in what direction the price of a stock or bond will go. Shiller is a leading proponent of the idea that markets, driven as they are by human psychology, can create large and sustained mispricings, such as in the late 1990s when excessive optimism drove the stock market into bubble territory. He is a student of "behavioral economics," the study of how quirks in human psychology can create results that traditional economic theory would not predict.

1 of 7 15/10/2013 7:13 AM The economics Nobel goes to: Eugene Fama, Lars Hansen and Robert ... http://www.washingtonpost.com/blogs/wonkblog/wp/2013/10/14/the-...

With the joint award, the Nobel committee was in effect fusing those competing schools of thought into a unified theory to recognize what economists now understand about where asset prices come from.

"The Laureates have laid the foundation for the current understanding of asset prices," the committee said in its announcement of the prize, formally known as the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. "It relies in part on fluctuations in risk and risk attitudes, and in part on behavioral biases and market frictions."

Fama's research is fundamental to modern finance theory, though his work has been tarnished some in recent years by wild swings in financial markets that have suggested they are anything but rational. His seminal paper "Random Walks in Stock Market Prices," from 1965, is part of a body of work that casts doubt on any theory that we can predict the future value of a stock or bond merely by looking at a price history chart. His work showed instead that the movement of an asset price is a "random walk" in which the price rises or falls based on new information (say, word of a company's sales, or the future direction of interest rates) and that this information is immediately incorporated into and asset's price.

Fama's "efficient markets hypothesis" holds that investors can do just as well or better by investing in stock index funds as they can by trying to time the market and pick individual stocks. Anything they think they know about the future prospect of a company, in other words, is almost certainly already reflected in its share price.

Shiller, 67, challenges some key aspects of the efficient markets hypothesis. In a 1981 paper, for example, he demonstrated that stock prices are much more volatile than the underlying trends in the dividends they pay would suggest. He went on to show that periods when stock prices are high relative to corporate earnings tend to be followed by periods of below-par returns, and vice versa.

Hansen, 60, built on Shiller's work in important ways by using new statistical methods to test what exactly was driving all that stock price volatility. Hansen's work established more strongly the idea that the mispricings Shiller identified had to do with fluctuations in how much appetite for risk people had. When times are bad, for example, investors become more cautious, and when times are good more investors are willing to pay high prices for assets.

The insights of these and other economists led to skepticism on the multitrillion-dollar mutual fund industry, where savers pay hefty fees to have their portfolios actively managed by stock-pickers. If Fama's insights are correct, then the fees are wasted money -- paying stock pickers who won't actually increase the returns on investments over time. That, in turn, led to the growth in passively managed, low-fee, index funds.

Shiller's work has particular relevance for home prices. In the mid-2000s, for example, housing prices in the United States and several other nations rose to levels far above traditional valuations relative to rents. As Shiller's work predicted, this was driven by excessive optimism about future prices; as Shiller's work also predicted, this period of high prices has been followed by one of uncommonly low returns. (Shiller is the co-creator of the widely followed Case-Shiller home price index, which quantifies those shifts in U.S. housing prices.)

"Understanding how mispricing of assets emerges," wrote the Nobel committee, "and

2 of 7 15/10/2013 7:13 AM The economics Nobel goes to: Eugene Fama, Lars Hansen and Robert ... http://www.washingtonpost.com/blogs/wonkblog/wp/2013/10/14/the-...

when and why financial markets do not efficiently reflect available information, is one of the most important tasks for future research. The answers may turn out to depend heavily on the particular contexts and institutional settings, but they will no doubt be extremely valuable for policymakers as well as practitioners."

The fusion of Fama's, Hansen's and Shiller's research, then, boils down to this: We know that stock prices behave randomly on short-term horizons, and that efforts to time the market in the short run are probably counterproductive. But we also know that markets can become broadly mispriced for long periods due to the mysteries of human psychology.

View Photo Gallery —Eugene Fama and Lars Peter Hansen of the University of Chicago and Robert Shiller of Yale University were awarded the Nobel Prize in economics. Their research, when fused together, helped answer the critical question of what determines the prices of an asset, whether a stock, bond or house.

Neil Irwin is a Washington Post columnist and the economics editor of Wonkblog. Each weekday morning his Econ Agenda column reports and explains the latest trends in economics, finance, and the policies that shape both. He is the author of “The Alchemists: Three Central Bankers and a World on Fire.” Follow him on Twitter here. Email him here.

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Keith Cossairt wrote:

7:07 AM GMT+1000

3 of 7 15/10/2013 7:13 AM The economics Nobel goes to: Eugene Fama, Lars Hansen and Robert ... http://www.washingtonpost.com/blogs/wonkblog/wp/2013/10/14/the-...

currrently the answer is...... FED POLICY AND QE DETERMINE ASSET PRICES.

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anon73 wrote:

5:21 AM GMT+1000

If you want to understand why these three won the prize, try reading what THEY ACTUALLY WROTE. On the radio and in the newspaper reports that I have read today, it is clear that the reporters do not even come close to understanding. This is not surprising since it is not what most reporters know about.

All three are trying empirically to get a grasp on the nature of the determinants of asset returns. You can find their actual work at the following pages.

Hansen: http://larspeterhansen.org/ Shiller: http://www.econ.yale.edu/~shiller/ Fama: http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=998

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geezjan responds: 5:28 AM GMT+1000

Nah, I don't care to read what they wrote, any more than I'd care to read a paper on alchemy or a perpetual motion machine.

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anon73 responds: 6:55 AM GMT+1000

That comment explains a lot about the nature of the news reports.

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The Ultimate Avenger wrote:

5:06 AM GMT+1000

The poster below, geezjan, is spot on. This was not one of the original Nobel prizes and was a way to get of the sheen from the originals passed on to them.

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MtVernonCannibisFarms wrote:

5:06 AM GMT+1000

politicians re-engineering 20% of the worlds largest economy and the Noble economics committee didn't choose ObamaCare ???

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Keith Cossairt responds: 7:09 AM GMT+1000

NAW....OBAMACARE prize is for wealth transference.

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geezjan wrote:

4:58 AM GMT+1000

Ah, the annual fake Nobel prize created by a bank (not Nobel) in 1968 to try to promote the phony science known as "economics" and therefore to legitimize the use of economics to steal from the working classes to benefit the rich. Read all about it...

http://en.wikipedia.org/wiki/Nobel_Memorial_Prize_in_Economic_Sciences

4 of 7 15/10/2013 7:13 AM The economics Nobel goes to: Eugene Fama, Lars Hansen and Robert ... http://www.washingtonpost.com/blogs/wonkblog/wp/2013/10/14/the-...

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jodejong wrote:

3:22 AM GMT+1000

The previous commenter, who asked "Where is my 1.3 Million?," hit the nail on the head. I discovered little that I hadn't long known. My learning source was simple - common sense; That seemed to be the source of most of what the Nobel laureates had to say, as well.

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chickster wrote:

2:48 AM GMT+1000

When they get around to basics and a logic-based mathematical model which applies to the present and also demonstrates what has occurred over the past two thousand years or more for various political and geographic models, then they will have accomplished something. In the meantime they merely keep picking fly poop out of pepper wit5h gloves on.

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mwoss wrote:

2:33 AM GMT+1000

If everybody is trying to undermine the economic policies based on economic theories deduced from past economic behavior as has been stated below. it is obvious that economics is not something to be used to create future government policy. Then why all the crying by this faction or that faction to follow this economist or that one? Could it be that those crying already have their exploitation plans in place and are trying to get policies in place allowing them to execute those plans - which usually will means the rest of us pay for their gains since the gains will not come from the creation of real godts and service but only the change in asset prices?

I used to wonder if economics had any use and why these people get paid so much and are so esteemed by the bought and paid for media. Using them as shills to get policies designed to be exploited by insiders sure makes sense to me.

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JoePhillipsLCSW wrote:

1:36 AM GMT+1000

Economics is still junk science. It's so primitive. It's not about predicting stock prices. It's supposed to be a SOCIAL SCIENCE. In the future we will reach a phase of FIREWALL ECONOMICS. Socialism for necessities and capitalism for everything else. Google it. Then we will pass into a compassionate socialism. But we are still very very primitive.

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mwoss responds: 2:03 AM GMT+1000

First of all, any social science is supposed to improve the human condition - in all aspects. Economics is one of the more junkier social sciences because so much of human interaction is ignored due to the biases of the practitioners and the inability to measure them.

What is the value of intact family units where the father earns enough to support his family without welfare. Remember what anybody "earns" is always part illusion. Here we have a proud father instilling in his sons and daughters the value of hard work. His kids look up to him and are proud of him. They have enough free time to develop their other talents such as music, art and other recreation. Who knows one of them may even invent the next big hobby that can employ thousands of people.

However, this has no value in economic models since a price cannot be put on it. You can try to estimate things like increased incarceration and so on but usually the whole thing is just ignored as some inconsequential outlier, not nearly important as how much we gain because Walmart dropped the price of their Chinese made pants this week.

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Dryly 41 wrote:

1:28 AM GMT+1000

5 of 7 15/10/2013 7:13 AM The economics Nobel goes to: Eugene Fama, Lars Hansen and Robert ... http://www.washingtonpost.com/blogs/wonkblog/wp/2013/10/14/the-...

Eugene Fama's "Efficient Market Hypothesis" has been proven to be pure unadulterated nonsense in 2008.

And he wins a Nobel?

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THINK ABOUT IT wrote:

1:20 AM GMT+1000

Nobel award winners ? How can we send these men Fama , Hansen , Shiller ; to teach , something to our executive congress groupies ~~~ clan --- in Washington .... ?

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mwoss wrote:

1:00 AM GMT+1000

Bubbles are no mystery to me - where's my Nobel Prize? The only analysis being done by people is that the price of something is rising and people are making money. People "invest" in pyramids or "airplanes" was one of there names at the time. Everybody knows it isn't a real investment and there isn't anything to back it up except the idea that as more people enter the scam the early ones make out like bandits. Everybody thinks they have the smarts to jump off early. It is the same with any bubble.

In the 1920s everybody knew the stock market was being manipulated by the wealthy. There were bull clubs of wealthy people and bear clubs. A bull club would buy stock and use the news sources they owned to pump it up and dump it. The bears would short it and talk it down. The average guy knew this and still wanted in on the action because they all thought they could get their little piece before the collapse came - they would not be greedy and take a little chunk before the big guys got out. Making more in a week than you did all year for doing nothing but calling a broker a few times is mighty enticing.

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Weebly wrote:

12:57 AM GMT+1000

...and therefore we should attack Republicans.

c'mon posters.

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Budget_in_Black wrote:

12:46 AM GMT+1000

Is this a happy day or not? Three Americans win Nobel prize in Economics! On one hand our country is the greatest Democracy on earth and we produce Nobel award winners every year! On the other, we don't allow these Nobel prize winners to tell us how to run our economy! And hence we constantly run into threats of Shutdowns and Debt limit crises. That's not very happy is it?

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Rwcan wrote:

12:38 AM GMT+1000

Fama and Schiller can be reconciled by a single fact: that knowledge and information have value. So, even according to Fama, yes, a good stock picker is worth the money, until his fees begin to approach the size of the incremental returns above the "random walk" results. And they will. As the government begins to participate more in markets, however, they become more opaque. Witness the surprise when Fannie and Freddie were finally forced to open their books. Schiller's understanding is true. But the "psychology" of risk aversion has never changed. Judgment is always guided by the available information. When that's distorted or withheld, markets have fewer reliable indicators.

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mwoss wrote:

12:32 AM GMT+1000

6 of 7 15/10/2013 7:13 AM The economics Nobel goes to: Eugene Fama, Lars Hansen and Robert ... http://www.washingtonpost.com/blogs/wonkblog/wp/2013/10/14/the-...

Where was warren Buffet in this award. He has only been saying that his whole investing life.Ask any professional stock picker and they will say the same thing about stock prices. If there anything more worthless than the Nobel prize in economics or economics itself I would like to see it.

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