Why This Year’s Nobel Award In Economics Makes Perfect Sense

Last week’s news on the choice of this year’s winners of the Nobel prize in economics perplexed and even disturbed some pundits. How could two economists—Eugene Fama and Robert Shiller—with such diametrically opposed ideas on asset pricing be awarded a Nobel at once? (A third winner, Lars Peter Hansen, shared the prize for his work in econometrics.) By some accounts, elevating the two names, and their respective bodies of work, in one Nobel award is misguided at best because it mistakenly suggests a degree of equality in the underlying methodologies for evaluating markets. I’ve heard some people argue over the past week that one or the other name should be stricken from the list. But that’s a foolish read on this year’s award. Giving the prize jointly to Fama and Shiller makes perfect sense because it reminds us that no one theory can tell us everything we need to know in the money game.

Fama, of course, is the father of the efficient market hypothesis (EMH), a theory that says that the market quickly and efficiently incorporates all known information into asset prices. The implication is that it’s hard if not impossible to outguess Mr. Market. Shiller, by contrast, has spent years documenting EMH’s shortcoming, including a widely cited study (pdf) that documented that stock prices are far more volatile than can be explained by subsequent changes in dividends.

But if Shiller and Fama have been promoting opposite and conflicting causes over the years, the enlightened investor now realizes that considering their research together is actually quite practical. The markets are neither perfectly rational nor hopelessly irrational. The truth lies somewhere in the middle, albeit in fluctuating degrees through time. As a result, if you assume a hard line on either one of these fronts, you’re asking for trouble.

The idea that the markets are close to efficiency at all times is simply asking too much. If you really thought that way, you’d never question anything Mr. Market does. A highly priced market or extreme returns, up or down, would have no impact on your choices for asset allocation and rebalancing. But a large body of evidence shows us that such an extreme view is dangerous.

But that doesn’t mean we can dispense with EMH and its implications for money management. I often write on these pages that there are several reasons why you should customize Mr. Market’s asset allocation for your own purposes, based on risk tolerance, investment horizon, and so on. But I’m careful to add that there’s one reason why you shouldn’t question Mr. Market’s investment strategy. If you think you’re smarter than the market on a regular basis, you’re setting yourself up for disappointment, perhaps deeply so.

It’s become increasingly clear that blending the insight from the efficient-market and behavioral wings of finance offers more real-world value than blindly focusing on either side to the exclusion of the other. For example, building a portfolio based on index funds and rebalancing the mix when trailing returns move to relative extremes draws a lot of strength from research by Fama and Shiller.

The possibility that these two economists represent a degree of complementary insight for managing portfolios in the real world drives some pundits nuts. The search for purity and clear-cut narratives in finance is a quest that some investors and analysts embrace as if they’re on a religious mission. But the only thing that matters in money management is progress in boosting risk-adjusted returns. Everything else is a sideshow. The reality is that Shiller and Fama have taught us a lot when it comes to thinking about how markets work and what that means for building and managing portfolios. In other words, awarding these two economists the Nobel prize is an informed choice about what we know with asset pricing. In fact, the Nobel committee pointed this out rather persuasively in the first line of the press release:

There is no way to predict the price of stocks and bonds over the next few days or weeks. But it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years. These findings, which might seem both surprising and contradictory, were made and analyzed by this year’s Laureates….

This piece is cross-posted from The Capital Spectator with permission.