A trio of American scholars were recently awarded the 2013 Nobel Memorial Prize in Economic Sciences. Eugene Fama and Lars Peter Hansen, professors at the University of Chicago, and Robert Shiller, a professor at Yale University, will share the honor and the $1.2 million award.1
The three economists made far-reaching discoveries related to the workings of financial markets, asset prices, and behavioral finance. Here’s a closer look at how their research contributed to the formation and refinement of fundamental concepts in portfolio management and long-term investing practices.
Father of Modern Finance
Eugene Fama introduced the efficient markets hypothesis in the 1960s. It is based on the premise that asset prices adjust quickly and are an accurate reflection of all relevant information. His research found that movements in stock prices are unpredictable, following a “random walk” that makes it extremely difficult for investors to choose outperforming individual stocks on a consistent basis or to predict the right time to buy or sell financial assets (market timing).2
The realization that trying to “beat the market” is often fruitless eventually led to the introduction of index funds designed to track the holdings of broader market indexes such as the S&P 500. At the end of 2012, 373 index funds managed more than $1.3 trillion in total net assets. About one-third of U.S. households with mutual funds owned shares in at least one index fund.3
In later research, Fama determined that market capitalization and valuation can affect the risk and return potential of equity investments.4
The return and principal value of stocks and mutual funds fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. Investments seeking to achieve higher returns also involve greater risk.
Accounting for Human Nature
In 1981, Robert Shiller published a ground-breaking study that seemed to contradict Fama’s theory that markets are always efficient. If they were, stock prices would generally mirror the growth in earnings and dividends.
Shiller’s research showed that stock (and bond) prices fluctuate more often than changes in companies’ intrinsic valuations (such as dividend yield) would suggest.5 He concluded that asset prices sometimes move erratically in the short term simply because investor behavior can be influenced by emotions such as greed and fear.
Shiller believed that human psychology could cause “bubbles” to form in asset markets. Investor enthusiasm (“irrational exuberance”) and a herd mentality can create excessive demand for “hot” investments, driving up prices until they become very expensive relative to long-term values.
In fact, Shiller became well known in the 1990s for warning that rapidly rising stock prices during the Internet boom could lead to a bubble that would eventually burst, causing values to collapse. He had similar warnings in the last decade about the run-up in housing prices, and he helped develop one of the most closely watched indexes of home values.6
A Scientific Approach
Lars Peter Hansen developed a statistical method that is widely used to test theories of asset pricing, including those advanced by Fama and Shiller. The Generalized Method of Moments is an econometric tool that helps estimate the relationships between important variables that are hidden inside large amounts of financial and economic data.
Hansen’s work improved on older methods for “formulating, analyzing, and testing dynamic economic models in environments with uncertainty.” His techniques have been adopted by social scientists in many other fields.7
The work of all three economists supports the notion that asset prices can be difficult to predict in the short run, but markets tend to weigh their prospects more accurately over longer periods of time.
This reinforces the importance of committing to a long-term investing strategy that fits your financial goals and risk tolerance, which may help you avoid costly, emotion-driven mistakes.
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1) The Wall Street Journal, October 14, 2013
2, 4–5) InvestmentNews, October 14, 2013
3) USA Today, October 15, 2013
6) CNNMoney, October 14, 2013
7) The University of Chicago, 2013
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