Sharing Nobel Honors, and Agreeing to DisagreeBy ROBERT J. SHILLER
Published: October 26, 2013
The Nobel Memorial Prize in Economic Science has sometimes been awarded to economists who disagree profoundly. Notably, in 1974, the Nobel committee gave a joint prize to Gunnar Myrdal, a Social Democrat in Sweden and a proponent of the welfare state, and Friedrich Hayek, a conservative who believed that government should be minimal.
This time, the prize given to Eugene Fama and Lars Peter Hansen of the University of Chicago and me for “empirical analysis of asset prices” is similarly discordant. So many people have been asking me about this obvious incongruity that I thought I should address it directly here.
Professor Fama is the father of the modern efficient-markets theory, which says financial prices efficiently incorporate all available information and are in that sense perfect. In contrast, I have argued that the theory makes little sense, except in fairly trivial ways. Of course, prices reflect available information. But they are far from perfect. Along with like-minded colleagues and former students, I emphasize the enormous role played in markets by human error, as documented in a now-established literature called behavioral finance.
The conflict between the third winner, Professor Hansen, and me is less marked. In fact, he is well known for having rejected one form of the efficient-markets model, in a famous paper with Kenneth Singleton, now at Stanford. Professor Hansen has developed a procedure, called the “generalized method of moments,” for testing rational-expectations models — models that encompass the efficient-markets model — and his method has led to the statistical rejection of many more of them. His sympathies still seem to be with rational expectations and efficient markets, though.
Actually, I do not completely oppose the efficient-markets theory. I have been calling it a half-truth. If the theory said nothing more than that it is unlikely that the average amateur investor can get rich quickly by trading in the markets based on publicly available information, the theory would be spot on. I personally believe this, and in my own investing I have avoided trading too much, and have a high level of skepticism about investing tips.
But the theory is commonly thought, at least by enthusiasts, to imply much more. Notably, it has been argued that regular movements in the markets reflect a wisdom that transcends the best understanding of even the top professionals, and that it is hopeless for an ordinary mortal, even with a lifetime of work and preparation, to question pricing. Market prices are esteemed as if they were oracles.
This view grew to dominate much professional thinking in economics, and its implications are dangerous. It is a substantial reason for the economic crisis we have been stuck in for the past five years, for it led authorities in the United States and elsewhere to be complacent about asset mispricing, about growing leverage in financial markets and about the instability of the global system. In fact, markets are not perfect, and really need regulation, much more than Professor Fama’s theories would allow.
It’s interesting that Professor Fama is also the intellectual father and major adviser of an investment company that has, by many accounts, been beating the market. The company, Dimensional Fund Advisors, has impressed investors with its performance so much that its assets under management have grown to $296 billion, as of Aug. 31.
So, how does D.F.A. reconcile the successes with Professor Fama’s efficient-markets theory?
The D.F.A. Web site refers to the “dimensions” of investing, reflecting the name of the company. First on the list of dimensions are “size” (the stock returns of small companies tend to do better) and “value” (low-priced companies tend to have better returns as well). Indeed, Professor Fama’s work with Kenneth French of the Tuck School of Business at Dartmouth has shown that historically, these dimensions could be used to deliver higher return for investors.
Now, many of us are accustomed to describing these size and value anomalies as reflecting market inefficiencies, or investor errors. This is especially true with regard to value. Wouldn’t you think that some overzealous investors would sometimes cause some stocks to be overpriced, and that one should stay away from them? That kind of pricing error and inefficiency creates value stocks. D.F.A., and Professor Fama, use different language, referring to “risk premia.”
Professor Fama avoids theories that describe these risk premia as even possibly reflecting irrational behavior, and I think he’s wrong about that. Still, he has ended up with an investing approach that looks, in some of its fundamental principles at least, a little like my own.
I can even recommend that people might consider investing in D.F.A.
I would not, however, recommend that monetary or fiscal authorities seek inspiration from his theories on how to stabilize the economy. He doubts the existence of any bubble before this crisis, and his philosophy would have let banks fail at the beginning of it.
Still, like Professor Hansen, Professor Fama is a first-class scholar who does careful research on the topics he focuses on.
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.
http://www.nytimes.com/2013/10/27/business/sharing-nobel-honors-and-agreeing-to-disagree.html?partner=yahoofinance&_r=0
