The Great Debate UK
from The Great Debate:
The 2013 Nobel Prize for economics celebrates that financial markets work, but cautions how little we know. One theme unifies the work of all three winners: Eugene Fama, Robert Shiller and Lars Hansen -- risk. (A disclosure: until August I worked at Dimensional Fund Advisors, where Fama is a director and consultant.) Risk is unpredictable, but can be very profitable. That sounds simple enough, but it has profound implications -- not only for the lords of high finance, but households, too. Risk teaches humility, to overconfident investors and also policymakers. That humility was notably absent at the IMF/World Bank meetings last week. Policymakers should take special note of the prize this year; it reveals how little we really understand about financial markets.
Fama’s work showed that prices incorporate all available information; this is known as the efficient market hypothesis. The implication is that you cannot systematically outperform the market, unless you have information other people don’t or can access part of the market others can’t. But that doesn’t mean you can’t make money. Over time you can expect, but are not guaranteed, that riskier assets generate higher returns. Stocks, on average, return more than bonds because they are riskier. The stock of smaller companies is riskier than larger ones, so they typically generate more returns. It’s a straightforward concept, but often poorly understood. Even many sophisticated investors get it wrong.
The implications of this theory changed markets, even for the average investor. The concept of efficient markets helped create demand for index funds. Index funds are a type of mutual fund, which is a collection of many different stocks. Active funds profess to know which stocks will outperform the market. Index funds don’t make that promise; stocks are weighted by their size relative to the rest of the market or use a weighting based on identifiable price or size characteristics. Because there’s no magic formula or talent presumed in constructing these funds, they are cheap; if no one can beat the market, why pay 1 or 2 percent of your assets to someone who claims they can? If you believe in efficient markets you’d only hold index funds. This has been revolutionary for the average investor. Through the 1960s few Americans owned stock at all, and if they did they only held a handful of individual stocks, which was very risky. Now about 50 percent of the population owns stock, mostly through mutual funds and increasingly with allocations based on indexing. The average household can invest as well as many hedge funds, for a fraction of the price. The existence of index funds shows that the best innovations (in finance or any industry) are often the simplest.
Fama’s later work, and the work of the other new Nobelists, further refined our understanding of risk. Fama’s more recent work helped us understand what kinds of risk investors are compensated for and how the return from risk varies over time and with economic conditions. Shiller’s work showed that asset prices are more volatile than models would predict, but there may be some predictability to returns over long horizons. Shiller may be skeptical that asset prices accurately reflect all information, but he still believes markets work. He advocates more financial innovation, based on his ideas, including products that hedge housing price risk and swings in economic activity.
–Juha Ylä-Jääski (D.Tech.) is President and CEO of Technology Academy Finland. The opinions expressed are his own.–
The 2013 Nobel season is once again gorging on a Grand Cru vintage of scientific achievement. Today, the Nobel Prize for Chemistry was awarded to three scientists, Levitt, Karplus and Warshel, whose multinational collaboration laid the foundation for the computer models crucial for most advances in chemistry today. Yesterday, Peter Higgs and Francois Englert won the Nobel Prize for physics for conceiving the so-called “God particle” which explains why the Universe has mass. Another trio were recognised on Monday when the Nobel Prize in physiology or medicine was awarded to Rothman, Schekman and Südhof for solving the mystery of how the cell transports crucial cargo.
And the Nobel laureate for economics in 2010 is?
Thomson Reuters expert David Pendlebury might have an idea. At least one of the picks from his annual predictions of winners (economics, chemisty, and so on) has won a Nobel prize over the years. Here is his short-list for economics this year.
* Alberto Alesina of Harvard University in Massachusetts for research on the relationship between politics and macroeconomics, especially politico-economic cycles.