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

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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-... Sign In SUBSCRIBE: Home Delivery Digital Real Estate Rentals Cars Today's Paper Going Out Guide Find&Save Service Alley PostTV Politics Opinions Local Sports National World Business Tech Lifestyle Entertainment Jobs More Economy Industries Local Business Markets Policy & Regulation Technology World Business Capital Business On Small Business 9 ways the shutdown Our complete debt Janet Yellen in her What the shutdown is How the government Obamacare: What you will get worse ceiling explainer own words really about shutdown works need to know Economy Health Care Energy Immigration Shutdown FAQ Archives Follow: 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. How the government Obamacare: What you The curious evolution of The GOP has lost its shutdown works need to know climate science reason for being « PREVIOUS NEXT » Wonkbook: Democrats have some demands, Absolutely everything you need to know too about the debt ceiling By Ezra Klein and Evan Soltas October 14, 2013 By Brad Plumer October 14, 2013 Comment Discussion Policy | FAQ | About Discussions Type your comment here Sort: Newest First Comments Live 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. Like· Reply · Share · Report Abuse 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 Like· Reply · Share · Report Abuse 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. Like· Report Abuse anon73 responds: 6:55 AM GMT+1000 That comment explains a lot about the nature of the news reports. Like· Report Abuse Add your thoughts... 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. Like· Reply · Share · Report Abuse 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 ??? Like· Reply · Share · Report Abuse Keith Cossairt responds: 7:09 AM GMT+1000 NAW....OBAMACARE prize is for wealth transference.
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