Monday, November 25, 2013

Economists disagree and the Nobel Prize in Economics

Economists are famous, perhaps infamous, for disagreeing with each other. Indeed, economists have
different views on policies, different scientific judgments, and different values. Even economists who share the Nobel Prize in Economics sometimes disagree with each other. This year the prize was given to Eugene Fama, Lars Peter Hansen, and Robert Shiller for highly influential but contradictory theoretical and empirical analysis of asset prices. The huge importance of their research stems from our every day choices between saving in the form of cash, investing in stocks, and real estate. Our decisions depend on our evaluation of the risks and returns associated with these forms of saving. Modern economy also depends on the understanding of asset prices as they provide information for key economic decisions regarding physical investments and consumption. Mispricing of assets leads to financial crises and can damage the overall economy.

The differences in the laureates’ research are well known in the finance community. They also have quite different policy implications. Answering the surprised public, Robert Shiller wrote “We disagree on a number of important points, but there is nothing wrong with our sharing the prize. In fact, I am happy to share it with my co-recipients, even if we sometimes seem to come from different planets.”(

In the center of the disagreement is the question of whether asset prices are predictable. Clearly, you can make a lot of money if you can predict with a high degree of certainty that one asset will increase more in value than another one. In the 1960s, Fama advanced the efficient-markets theory, which states that prices reflect all publically available knowledge, which implies that average investor can’t beat the market. It also implies that prices follow a random walk, go up or down, which makes deviations from expected returns unpredictable and arbitrage impossible. Fama’s empirical studies supported very limited short-run predictability in stock markets. Even if an asset’s actual price goes above or below its expected price, such deviations are so small that trading costs would exceed any gains from arbitrage. Many concluded that if prices are virtually impossible to predict in the short run, they are even less predictable over longer time horizons. A practical take away from the efficient market theory is that trading by using complex algorithms is no better than by just flipping a coin. You can accidentally have a long series of luck but publicly available information will not ensure you could systematically beat the market. However, in the 1980s, Shiller’s studies of stock-price volatility and longer-term predictability challenged this conclusion. He showed that stock prices exhibit excess volatility – that is, prices significantly deviate from the expected levels in response to events affecting asset prices, such as dividend news – in the short run, and over a few years the overall market is quite predictable. On average, the market tends to move downward following periods when prices are high and upward when prices are low.

 Moreover, Shiller suggested some behavioral explanations for asset prices’ excess volatility, which inspired a new field called behavioral finance. For example, he suggested that there are two types of investors: experienced rational investors and so-called “ordinary investors.” Unlike rational investors, the ordinary ones fail to recognize and utilize arbitrage opportunities. Instead of responding to expected returns, they are highly susceptible to the opinions of others about stock prices, similar to fads or fashions. As a result, their trades exacerbate deviations of stock prices and generate excess volatility, which generates arbitrage opportunities for others.

One of the most difficult issues in modeling financial markets is uncertainty. The theory acknowledges that investment decisions involve risk but they also assumes that investors are aware of how markets work and have access to the true data, which allows them to process information efficiently. In real life, we have to deal with very limited information, as there are too many variables that we can neither observe nor measure directly. Hansen has made a lot of progress developing and testing a variety of asset pricing models which allow studying complicated systems with limited information. ( )

Why did the Nobel Committee decide to award a joint prize? Fama, Hansen, and Shiller explored price predictability from different angles and produced important empirical findings with important practical implications. For example, Fama’s research inspired the creation of index funds – mutual funds tracking the performance of a particular index, a convenient way to participate in the stock market and diversify a portfolio – in the early 1970s, which has grown to account for over 40% of the worldwide flows into mutual funds. In turn, Shiller’s research is behind the S&P Case-Shiller index that is now the standard real estate price index in the United States. So, it looks like we are from the same planet, after all.

Discussion Questions

1. Why do some people gamble regularly while others would never even consider making a bet?

2. Why are behavioral economics, for which Vernon Smith and Daniel Kahneman received a Nobel Prize in 2002, and now behavioral finance gaining more popularity in the academic and business community?

3. If you had $500 to invest, how much would you invest in an index fund and how much would you put in an individual stock that you thought was going to perform well?

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