David R. Henderson  

Henderson on Fama, Shiller, and Hansen

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Sometimes the Nobel committee seems to make a partly political statement in choosing winners of the prize in economics. Not this year. On Monday, the Royal Swedish Academy of Sciences awarded the 2013 Nobel to three deserving American economists: Eugene Fama and Lars Peter Hansen at the University of Chicago and Robert Shiller of Yale University. The prizes were based on the importance of their work, which "laid the foundation for the current understanding of asset prices."
This is the opening paragraph of my op/ed, "A Nobel for the Random Walk of Stock Prices," Wall Street Journal, October 14, 2013.

For all but 5 years since 1996, I've written the Wall Street Journal op/ed on the Nobel prize winners in economics. In those 5, either I was traveling and not equipped to do it, or I was not informed enough to do it. Yesterday, I wrote the WSJ piece on Fama, Shiller, and Hansen.

I've been waiting for years for Eugene Fama to win, and I'm delighted that he did. Most important, I thought he deserved it long ago and, less important, writing the section on him was easy. I know Shiller's book, Finance and the Good Society, well, having reviewed it for Regulation. I knew his academic work less well. And I knew little about Hansen.

Another excerpt, emphasizing what is important about Fama's Nobel for us great unwashed:

One implication of market efficiency is that trading rules, such as "buy when the price fell yesterday," don't work. The insight has had big implications for large and small investors: Don't waste your money on professional financial managers who actively try to pick individual stocks.

One high-profile beneficiary of Mr. Fama's insight was John Bogle, who started the Vanguard 500 Index Fund in the 1970s. His idea was to have a fund indexed to the overall market and save the costs of hiring experts to predict stock prices. He shared Mr. Fama's skepticism about golden stock-pickers. The result is that over the past four decades millions of investors who buy index funds from Vanguard and its competitors have saved hundreds of billions of dollars by not paying for dubious investment advice.


When I arrived at the University of Rochester business school in 1975, I quickly learned about Fama's work from Michael Jensen, John Long, and Clifford Smith. It has paid dividends, so to speak, for my investments over about 30 years.

Particularly helpful to me were three people: George Mason University's Tyler Cowen and Alex Tabarrok of Marginal Revolution and University of Chicago's John H. Cochrane, aka The Grumpy Economist. Tyler and Alex always do a great job of telling readers about the Nobel recipients' work; this time they did even better. In fact, I ran a version of my piece by both Alex and John, to make sure I got things right. John helped me with my understanding of Hansen. I quoted Alex but, in the editing process, it was taken out.

The best explanation of Hansen's work I've seen, which I saw only after my piece was closed, is by Jeff Leek at "Simply Statistics." My guess is that, even though I understood Hansen better after reading it, I would not have been able, in 100 or so words, to do an adequate explanation.

Russ Roberts has interviewed both Fama and Shiller for Econtalk.

My quote from Fama on bubbles is from this interview in the New Yorker.


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COMMENTS (13 to date)
Grant McDermott writes:

David,

Speaking of Michael Jensen and Nobel Prizes, this might interest you.

[broken url fixed--Econlib Ed.]

Pat writes:

I learned a lot from Long and Smith at Simon. (I was Cliff's designated punching bag in Corporate Finance. It considered it a badge of honor!)

For what it's worth, I learn just as much from you and your co-bloggers and it costs a lot less. Thanks.

Bostonian writes:

Is the market efficient, though? Fama himself (along with frequent co-author Ken French) showed that "cheap" stocks with low price/book ratios outperform expensive stocks with high ratios. I don't think most academics have found risk-based explanations of the value anomaly convincing.

People like Ben Graham were advocating value stocks decades before Fama and French admitted there was a value anomaly. I think there is a tendency among finance academics towards intellectual herding, ignoring what practitioners do and write until a prominent academic such as Fama makes a line of inquiry respectable.

Greg G writes:

So the Efficient Markets Hypothesis led to the development of stock market index funds. And the great success of index funds over actively managed funds is perhaps the best evidence in favor of the Efficient markets Hypothesis.

But ironically, the failure of most investors to incorporate this very easily publicly available information into their investing decisions is perhaps the best evidence against the Efficient Markets Hypothesis. The average investor pays thousands of percent a year more in fees for financial management (usually with worse performance) than they would have in a Vanguard Index Fund.

Why is this the case and why isn't it viewed as more of a challenge to the Efficient Markets Hypothesis?

Kidbuck writes:

Maybe markets are only as efficient as their weakest members? Maybe participants operate on a Gaussian curve reflecting their ignorance and intelligence, degrees of interest and effort. In short, markets are as perfect as their participants.

David R. Henderson writes:

@Greg G,
But ironically, the failure of most investors to incorporate this very easily publicly available information into their investing decisions is perhaps the best evidence against the Efficient Markets Hypothesis.
No. It's not evidence against EMH at all. EMH says that publicly available info is quickly reflected in stock prices. It says nothing about whether most investors will act accordingly.

Greg G writes:

David

I am aware that there are several versions of EMH. Maybe Fama did intend it only to apply to stock prices. Even so, it is difficult to understand why the same effects wouldn't apply to other financial assets.

David R. Henderson writes:

@Greg G,
You're missing my point. EMH is about assets, not investors. I'm pretty sure Fama would say it applies to other financial assets too. What EMH does not imply is that most investors will incorporate the information into their investing decisions.

jure writes:

Hello everyone,


David

But if information is quickly reflected in prices as EMH says, this means that investors do incorporate available information into their investing decisions. Prices are nothing else than reflection of investing decisions. If information exists and investors do not take action accordingly- than markets cannot be efficient. That means that EMH necessarily implies decision making according to available info. After all, investors are nothing else than messengers or middle men between information and price. Or differently, prices cannot be efficient if there is no investor who acts. What do you think about it?

Greg G writes:

David

I understand your point that investors and assets are different things but that only helps a little as jure points out. We normally expect all markets to be a lot more efficient than the market for stock market mutual funds is and they normally are.

When I was a local clothing retailer I could get at most a 10% premium if I offered better service and selection than my local competitors. If I tried for more than that I lost market share fast.

Sellers of mutual funds can routinely get astonishing premiums for the same (or much worse) products. I don't claim to understand why but I think it is an interesting theoretical problem that should get a lot more attention.

Charley Hooper writes:

Isn't it interesting that Fama got a Nobel prize for showing that stock markets are efficient while Shiller got one for showing that stock markets aren't efficient?

Charlie writes:

I don't know if you picked the title, and I can't read the WSJ article, but I don't think it is accurate to call this a Nobel for a "random walk of stock prices." In the olden days, academic finance tended to assume that stocks move randomly around an expected market return.

Part of Fama's seminal contribution, was that the EMH is also consistent with stocks moving randomly around a changing risk premium. Shortly after Merton (1973) created such a model. Later Fama and Shiller would go onto to show that expected risk premiums do change. Shiller attributes it to changing sentiment, while Fama attributes it to changes in risk over the business cycle.

Hansen came up with a way to test theoretical models with asset pricing and macroeconomic data. He linked theory to empirics in an innovative way, so we can test models of the changing risk premium.

Perhaps, one could say that it is a Nobel for a random walk with a stochastic drift term that depends on economic state variables. Is that what you meant?

David R. Henderson writes:

@Charlie,
I don't know if you picked the title
I did not. I've learned never to invest in a title, no matter how good the title is that I think of. Choosing a title is a waste of time.
You point out some problems with such a title. Here's an even bigger one: Stock prices are NOT a random walk or even close to it. It's the CHANGES in stock prices that were originally alleged to be a random walk.

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