How the Nobel economists changed investing forever

October 15, 2013

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.

Hansen’s work provided a way to measure how variables interact without presuming a perfect knowledge of how risky they are. His methods have been used in finance and macroeconomics. As the last five years have shown, financial risk has profound effects on the real economy. But how and through what channels is not well understood; macroeconomists often make unrealistic assumptions about risk or ignore it altogether. But even though Hansen pioneered new ways of using data to understand macro models of the economy and finance, he stresses we should not overestimate what we know.

What we learned from the recent Nobelists is that risk is very important; risk drives asset prices; risk changes over time; and we can’t predict risk. One heard a different message at the IMF/World Bank meetings last week. There was little mention of financial market risk, other than uncertainty from the debt ceiling. Christine Lagarde insisted that the financial sector needs more policing and there was lots of excitement about “macro-prudential” policies — that is, where the central bank identifies areas of financial risk, decides it poses a danger and puts a stop to it.

Regulation is essential for any well-functioning market, but regulators must recognize their limitations. Risk rewards the people willing to tolerate it. That means some investors always crave risk; the harder it is to find, the more dear it becomes and the more people want it. The price of risk determines how capital is allocated; risky startups get the capital they need because they offer investors higher expected returns. The process is not always perfect, because investors might not be able to access certain markets or misconstrue information. But market-set asset prices convey more information than any alternative.

Some have interpreted the financial crisis as an indictment of efficient markets, but that view represents a misunderstanding of Fama’s work. In order to reject efficient markets you’d have to believe that, before the crisis, it was possible to predict exactly what was wrong, where, by how much, and at the precisely right time. Even Shiller, who “predicted” the Internet and housing bubbles, hasn’t always gotten the timing right. Indeed there were bad practices on Wall Street and many people underestimated the risks they’d taken. But if the bad actors in finance didn’t know — and they had a fantastic profit motive to figure it out — how can we expect policymakers and regulators to know better?

The most effective and healthy regulation is transparent, simple and doesn’t presume to perfectly manage risk. The more confusing and onerous the rules are, the more risk moves into the shadows and poses a greater threat. The Nobel prize this year validates how important, but limited, our understanding of finance is. As policymakers become more reliant on macro models of the economy, they’d be wise to keep that in mind.

PHOTOS: University of Chicago Professor Eugene Fama is pictured in his house after finding out he won the 2013 Nobel Prize in Economics in Chicago, Illinois October 14, 2013. REUTERS/Jim Young; Robert Shiller, one of three American scientists who won the 2013 economics Nobel prize, attends a press conference in New Haven, Connecticut October 14, 2013.REUTERS/Michelle McLoughlin; University of Chicago professors Lars Hansen speaks at a news conference after it was announced he won the 2013 Nobel Prize in Economics in Chicago, October 14, 2013. REUTERS/Jim Young



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No. No. Something rings untrue here. Nothing has changed. Investing is still a euphemism for speculating. The ability to measure risk in these ways will evaporate once every trader does it. The 1% will still get richer off of inside information. The losing gamblers will still get bailed out by the taxpayers. Sorry, but tomorrow will be just another day on Wall St.

Posted by BidnisMan | Report as abusive

Economists are not scientists, please stop trying to conflate the two. Economics being an arm of political science, it cannot be a natural science.

Posted by Benny27 | Report as abusive

I’m not an economist, but that sure seemed to make a lot of sense.

Posted by tmc | Report as abusive

The last paragraph here is the most cogent.

I wonder why John Bogle never got nominated a Nobel prize?

Posted by Missinginaction | Report as abusive

Any defense of rights of gambling for the wealthy necessarily contains holes, and this piece is no exception. This statement :
“But if the bad actors in finance didn’t know — and they had a fantastic profit motive to figure it out — how can we expect policymakers and regulators to know better?” stands out in particular, since (1) many banks and regulators did know a crisis was in the making, but continued regardless as it was massively profitable, (2) the existence of ‘too big to fail’ institutions means that banks currently have strong financial incentive to create and pop bubbles, as losses are socialized.

Posted by brianpforbes | Report as abusive

Higher risk has a potential for higher rewards. It also has the potential for high losses. That is how an efficient market “works”. Central bank policy is attempting to remove the chance for loss, meaning there is only “reward” to risk. This stance leads to the misallocation of money and causes asset bubbles, ie the dot com and housing bubbles. As long as the Central Banks can QE, this will work. But as the dot com and housing bubbles showed, at some point the music will stop and an implosion will occur.

Posted by canrancher | Report as abusive

brianpforbes rightly reminds us of those market participants who have been finding ways to gain trading profits whilst immorally transferring risk to those less able to understand the risks, without fulfilling their “duty of care”. Perhaps Ms. Shrager intends to discuss that in another article?
> “If you believe in efficient markets”
…Not sure I fully do. The “efficient markets” hypothesis is becoming gradually truer over time, as regulation gets a little more effective, as the dissemination/leaking of information gets normalized / harder to prevent, as online price-comparisons get easier for ordinary people to do and as automated trading augments the fallible intelligence of avaricious human beings. However, as Ms. Shrager rightly suggests in part:
complete truth ≠ available information
information deliberately disseminated by interested parties ≠ information required to make a responsible decision
risk ≠ perception of risk (note psychological theories of loss aversion etc.)
information ≠ knowledge ≠ intelligence
access to information ≠ capacity to process it
access to market ≠ willingness to take advantage of this access (we are creatures of habit, and like familiarity and feelings of trust).
The market does not function on risk, it functions on PERCEIVED RISK, which is often VERY different from real risk. Market participants do not act on information, they act on the information they have the capacity to acquire and intelligently process, which they have prepared themselves and done the work to understand (and even then, most market participants still perceive the market through a fog of emotions and a lens of greed.)
Einstein was brilliant, not because of his access to information or publishers that other scientists didn’t have, but because of his ability to perceive the workings of physics in a new way when looking at the very same data that other scientists had already examined! No algorithm could ever replace him.
Not every market participant will be an Einstein of trading (and even as a “crowd-sourced” “intelligence”, any market comprising a large component of fallible people and “flash-crash” algorithms is going to be less than “efficient” itself). Some intelligent people (who might uniquely be able to process certain information in correct combinations), may have access to very little capital! Every student of history knows that there are some very intelligent but very poor people, and some very stupid but very rich people (riches aren’t always proportional to intelligence).
Take a man who has worked in mining all his life, and who understands all the basic mathematics of the market and can visit the sites of mining firms you might invest in, talking with miners at grass-roots level in these companies; and if I were a betting man, I would wager every last penny I had that he would “outperform” expert market analysts with access to the exact same information, facilities and people!
The market may be “efficient”, but imagine what it COULD be if only the right people had relevant industrial market access and financial literacy!

Posted by matthewslyman | Report as abusive

They changed it? Investing seems like gambling to me now, is that what they were after?

Posted by Koan | Report as abusive

A little more thought on this matter has led me to pay more attention to the principles these Nobel Laureate economists have been expounding: short-term market movements are bound to be fairly random (within ranges and within trends determined by complex wider market circumstances); and it’s bound to be hard to predict stock movements over a short time horizon, because there’s only a finite amount of actual information. (There may be an infinite amount of disinformation, spin and rumor masquerading as “Market News”, and there may POTENTIALLY be an infinite amount of analytical intelligence; yet since there is only a finite amount of information and a finite number of ways of analysing that finite information, there will be a fundamental limit to the predictability of markets over short time horizons).
At least, that’s how I’m reading this, without actually reading the economic papers in question… (I should probably do that at some point!)

Posted by matthewslyman | Report as abusive