What the Nobel Prize Says About Our Economy

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There’s an old joke about the economics profession that says that it’s the only field where two people can win the Nobel Prize for saying the exact opposite thing. On Monday the joke was seemingly proven true when the Royal Swedish Academy of Sciences awarded the Nobel Prize to both Robert Shiller and Eugene Fama—two academics who have long been known for offering competing viewpoints on on how well markets price assets. (Lars Hansen was also recognized for his contribution to statistical analysis of asset price data).

Fama made his name in the late 1960s through work which helped show that the stock market is “efficient,” or that the price of a stock reflects all available information about that stock. The implications of this “efficient markets hypothesis” were manifold, but one of the most important for the average investor is that you can’t beat the market. Over the long run, the even the smartest and most dedicated investors aren’t going to be able pick stocks that beat the returns produced by the overall market.

This theory held up well over the years, especially when used to estimate an individual’s chances of figuring out something the market doesn’t already know. And the theory helped an entire generation of economists and financiers develop strategies on risk management and the proper compilation of an investment portfolio.

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Unfortunately, like any other economic model, the efficient market hypothesis falls short of fully explaining reality. And in the late 1970s and early 1980s economist Robert Shiller began to publish work that showed that while the stock market may be efficient at reflecting all available information about a particular company, the stock market also demonstrates irrational investor sentiment that may cause individual securities or an entire market to be over or undervalued. Here’s how Shiller himself explains his own thinking about the failures of the efficient market hypothesis:

“I used to be cowed by the efficient markets hypothesis, and now I think it’s a half-truth. It is true that money is harder to make a profit than you’d think, and randomness plays a huge role in your outcomes, investing outcomes. But it’s not true that markets are efficient, and in particular, aggregate markets are driven primarily, I believe, by investor sentiment.”

In recent years, Shiller has achieved a reputation for predicting the dot com bubble of the late 90s as well as the more recent real estate bubble — two events that had much of the economics community wondering if markets could be efficient if they allowed such disconnection between the fundamental value of an asset (like residential real estate in 2005) and the price it could fetch in the market. During the real estate bubble, credit markets overestimated the ability of borrowers to repay home loans, and real estate markets overestimated the value of real estate. This all came crashing down in 2008, forcing the world into a recession from which it is still recovering. 

But do these bubbles prove that Fama and the efficient market theory are incorrect? Not if you define the the theory as “markets incorporate all available information.” After all, they may still do this while, as Shiller suggests, incorporating things like investor’s irrational exuberance. Just because markets are efficient, it doesn’t mean that they are pricing assets correctly.

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In other words, it’s not exactly true that the Nobel Committee awarded the prize in economics this year to two scientists who hold diametrically opposed points of view. It did, however, reward economists laboring in an area that remains not well understood. The sort of analysis that Fama and Shiller won their award for was only made possible by advances in computing that began in the 1960s. And after half a century of some of the brightest minds in the world turning their attention to the subject of asset pricing, there remains a vigorous debate over what exactly markets can and can’t do.

That being said, Fama’s and Shillers’ insights provide valuable lessons for the average investor. On the one hand, listen to Fama the next time a smooth talking stock broker or fund manager comes to you saying he can promise you market-beating returns. Regardless of his track record, chances are you’re better off parking your money in a low-fee index fund that simply tries to match the overall performance of the market.

At the same time, Shiller’s work shows us that just because the market’s efficient, it doesn’t mean they’re always right. Be suspicious of those folks who tell you something is true just because the market says it’s so. Shiller’s insights also lends credibility to those who argue for more regulation of financial markets. If irrational exuberance is a common theme in financial markets, then government has a role to play in blunt the effects of the bursting of a credit bubble, for instance. Indeed, even Fama — known for his skepticism of government intervention — has come out in favor of tighter capital requirements for banks as one way to prevent another financial crisis.