The Ivory Tower Changes Wall Street
For as long as there has been a stock market, investors have sought a reliable framework to determine the future direction of prices. Success has been elusive. But thanks to the work of three American economists, we operate today with a better understanding than prior generations of what determines an asset’s price.
For their work, Eugene Fama, Lars Peter Hansen, and Robert Shiller were awarded the 2013 Nobel Memorial Prize in Economics. We can see the impact of their research in the development of low-cost index mutual funds and a methodology for identifying when home prices may reach irrational levels.1
Fama is considered the father of the “efficient markets theory,” which postulates that markets are exceedingly good at incorporating all known information into the value of an asset, making it difficult to predict the short-term direction of a stock or bond.2
Fama is famous for describing market movements as nothing more than a “random walk,” discounting the efficacy of price-prediction models. This view led to the conclusion that investors could do as well, or even better, by investing in a passively managed index fund.
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Shiller’s work brought us a different, even contradictory, view. His research suggested that mispricing of assets may occur because of human behavior, which can lead to excessively high or low prices relative to their true value. His work also focused on home prices, which employed a cost ratio between home prices and rent to ascertain fair value of current home prices. Shiller may be best known for his co-development of the Case-Shiller Home Price Index.
Lars Peter Hansen
Hansen’s research built on Shiller’s work, using statistical models to determine what drove market volatility. His work was more esoteric, but well valued by other economists. He concluded that the mispricings that Shiller had identified were connected to investors’ changing risk appetite. Hansen argued that investors become more risk averse during bad times and more aggressive during good times.
At first glance, it may be perplexing that the Nobel Committee awarded the prize to men espousing differing theories, but collectively, they made important contributions to our body of knowledge on how assets are priced.
1. Keep in mind that the return and principal value of stock prices will fluctuate as market conditions change. And shares, when sold, may be worth more or less than their original cost.
2. The market value of a bond will fluctuate with changes in interest rates. As rates rise, the value of existing bonds typically falls. If an investor sells a bond before maturity, it may be worth more or less than the initial purchase price. By holding a bond to maturity an investor will receive the interest payments due plus his or her original principal, barring default by the issuer. Investments seeking to achieve higher yields also involve a higher degree of risk.
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