2013 Economics Nobel Prize awarded to trio

The Royal Swedish Academy of Sciences has awarded the 2013 Economic Nobel prize to Eugene F. Fama, University of Chicago, IL, Lars Peter Hansen, University of Chicago, IL, and Robert J. Shiller, Yale University, New Haven, CT, all in the U.S.A., “for their empirical analysis of asset prices”.

This Nobel prize is officially called The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2013.

Although we are unable to predict the price of bonds and stocks over the short-term (the next few days or weeks), it is possible to forecast the broad course of these prices over a period of three to five years.

These were the surprising and seemingly contradictory findings of 2013’s Laureates Robert Shiller, Eugene Fama and Lars Peter Hansen.

Nearly fifty years ago, Eugene Fama and colleagues showed that predicting stock prices over the short-term is extremely difficult, and that new data is very rapidly incorporated into prices.

Fama and team’s findings completely changed market practice, as well as having a profound impact on how subsequent research was carried out.

If predicting prices over days or weeks is almost impossible, then surely trying to forecast them over several years is even more difficult. Robert Shiller discovered in the early 1980s that the answer to that question is “No!”

Shiller discovered that stock prices oscillate much more than corporate dividends, and that “the ratio of prices to dividends tends to fall when it is high, and to increase when it is low.” He found that this ratio held for bonds and other assets as well.

One approach interprets those findings in terms of how rational investors respond to uncertainty in prices.

The reward for holding risky assets during unusually risky times is high future returns.

Lars Peter Hansen developed a mathematical model that is especially good at testing rational theories of asset pricing. Using this model, Hansen and other investigators have discovered that modifications of these theories help explain asset prices.

Another approach concentrated on departures from rational investor behavior. Behavioral finance factors in institutional restrictions, such as borrowing limits, which stop smart investors from trading against any market mispricing.

The Royal Swedish Academy of Sciences wrote “The Laureates have laid the foundation for the current understanding of asset prices. It relies in part on fluctuations in risk and risk attitudes, and in part on behavioral biases and market frictions.”