Thoughts on Nobel Prize Winners Fama, Hansen & Shiller

Eugene Fama, Lars Peter Hansen & Robert Shiller have won the 2013 Nobel prize in Economics.  The RSAS (who awards the prize) stated:

“This year’s prize awards empirical work aimed at understanding how asset prices are determined. Eugene Fama, Lars Peter Hansen and Robert Shiller have developed methods toward this end and used these methods in their applied work. Although we do not yet have complete and generally accepted explanations for how financial markets function, the research of the Laureates has greatly improved our understanding of asset prices and revealed a number of important empirical regularities as well as plausible factors behind these regularities.”

A few initial thoughts:

• First of all, I think all three men deserve the prize (not that anyone cares whether I validate the committee’s decision!).  Their work has had a profound impact on the way people think about markets and they’ve done a great deal to bridge the divide between economics and finance.  That’s progress and they all deserve a great big thanks for their contributions.

 

• Fama and Shiller are seemingly at odds with one another.  Shiller has said the Efficient Market Hypothesis is a “half-truth” while Fama is largely responsible for making it a cornerstone of modern finance.

 

• It’s interesting that the Nobel Prize in economics went to three men who helped us better understand asset prices, but none of these men actually made a career as market practitioners working with asset prices.  I find that very strange.

 

The second point is probably not as interesting as most people think.  I view Shiller’s work as an expansion on Fama’s work.  The concepts that build the foundation of the Efficient Market Hypothesis are extremely helpful for understanding markets.  But they’re also somewhat incomplete and even naive in my view and I think Shiller has helped expand on this view by contributing a more realistic behavioral perspective.  For instance, the idea that the market is made up of rational participants who make the best use of their available information is a vast misrepresentation of the world we live in. To see how Fama thinks about the financial world consider this quote from 2007 on the housing market:

“Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed. The bottom line is that real estate is a huge component of wealth and we have no data on it. So the answer to your question is, Who knows?”

To put it bluntly, most people are actually pretty stupid when they buy houses.  Most people think their house is a great “investment” without even realizing that housing prices actually generate a negative real, real return over long periods of time.  Even worse, because home buyers are poorly informed, using highly deficient information and mostly just adhering to their behavioral flaws, they don’t always make “careful” decisions about buying.  The housing bubble was really the result of a credit bubble in which buyers falsely assumed they could afford more house than their incomes allowed in large part because banks allowed them to access that credit.  Then you had Wall Street’s mad scientists embedding false assumptions about how house prices never fall which led them to leverage various products up based in large part on the sort of thinking that is a cornerstone of Fama’s work (Fama is a master back tester whose conclusions about markets and prices are largely derived from an extremely thin historical data set).   The credit bubble was basically one huge risk miscalculation by lots of people involved.  (Fama explained the housing bubble away in a later interview by saying it was the government’s fault, which is just patently absurd in my view – government was a contributor, but not the only cause by a long shot).

That brings me to another quote from Fama that really irks me.  In 2010 he was asked about bubbles and credit markets.  He said:

“People who get credit have to get it from somewhere. Does a credit bubble mean that people save too much during that period? I don’t know what a credit bubble means. I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”

I’m sorry that this is turning into an anti-Fama rant (it’s really not!), but this is just wrong.  People who get credit get it from thin air when a bank makes a loan.  He’s almost certainly feeding some loanable funds model which is perfectly consistent with all the Chicago School economists.  So of course he doesn’t know what a credit bubble means because he doesn’t understand banking and he therefore isn’t using a model of the financial world that correctly reflects reality.  This is a really big deal to me.  It’s great to use models that simplify things and make them easier to digest, but when big parts of your model are based on fundamental flaws in the way the monetary system works then there’s something seriously wrong with the way you’re approaching the world.

All in all, I actually like a lot of Fama’s broad conclusions.  I like the idea that most people can’t predict future prices.  I like the idea that investors should cut down on fees and avoid most active managers.  And I think he’s done a lot to promote the idea of low cost funds and a more passive approach to markets.  That’s all good.  So, it’s not that I totally disagree with Fama’s findings.  It’s that I really don’t like how he arrives at them.  

I doubt Robert Shiller would disagree with too much in the above paragraph.  And I also assume he’d agree with the idea that Fama’s path to these conclusions is wrong.  And that’s where Shiller’s big contribution has been so valuable.  He’s added a new dynamic to this perspective by creating, what I believe, is a more realistic perspective of the way markets price assets in general.

Anyway, this is running longer than I have the time for, but the only other observation I had was that it’s interesting how we seem to rely on economists to understand market prices.  Maybe it’s just that market participants haven’t provided the relevant research or are usually too biased to tell us the truth about prices, but I do find it a bit odd that a prize awarded for understanding asset prices is being awarded to people who have very little experience actually working with asset prices….Then again, that’s coming from someone with no economics degree who often masquerades as an economist.  So put that in your cognitive biases pipe and enjoy!

All in all, I am happy to see Fama, Hansen and Shiller win the award.  We’re making progress in my view and that deserves to be rewarded.

For more research: 

Research by Lars Peter Hansen

The Capital Asset Pricing Model: Theory and Evidence – Fama

Market Efficiency, Long-Term Returns, and Behavioral Finance – Fama

From Efficient Market Theory to Behavioral Finance – Shiller