On October 14 the prestigious Royal Swedish Academy of Sciences awarded their annual Nobel Prize in Economics to three separate scholars with wildly different theories about the history of the market and stock movement.
Eugene Fama and Lars Peter Hansen of the University of Chicago, and Robert Shiller of Yale University, “laid the foundation for the current understanding of asset prices,” the Academy wrote in a statement explaining this year’s Economics picks.
It is interesting to note that while the men worked in the same field of research, they sometimes came to diametrically opposed conclusions.
Professor Fama is an interesting choice, as he is renowned for his Efficient Market theory, a hypothesis that is frankly out of fashion in economic circles. Fama asserts that markets are at their core rational, being automatically regulated by acting participants who are presumably motivated by concern for their own best interests.
His theory, first advanced in the 60s, began to fall out of favor as tech bubbles ravaged the market in the 90s. Efficient Market Theory lost additional public support in 2008, as the financial system began acting highly irrationally and nearly collapsed.
However, despite the loss of support for Efficient Market Theory, Fama’s work was recognized by the Academy for its lasting impact on investment theory. After all, the logical extension of his theory holds that since markets are rational and inefficiencies are self-corrected, investors can only beat the market via luck. Therefore, the smartest investment pick is a well-diversified portfolio that covers as much of the market as possible.
Lars Peter Hansen
The David Rockefeller Distinguished Service Professor of Economics at the famed University of Chicago, Hansen is the least ideologically severe of the three, as he is more focused on developing tools used by economists to analyze the market rather than advancing theories about the market itself.
Hansen is probably best known for developing econometric techniques that measure stock market volatility. In explaining his findings, Hansen attributed volatility to investor's differing attitudes towards risk. These models have been extrapolated past stock prices to encapsulate labor markets, finance, asset pricing, and the relationship between the financial sector and the broader global economy.
Hansen’s work confirmed several of the theories advanced by his co-winner, Robert Shiller.
The best-selling author and economic theorist Shiller is a New Keynesian, and the ying to Fama’s yang. Skeptical of the rationality of markets, Shiller asserts that markets can be “irrationally exuberant” when left to their own devices. Thus, markets tend to favor growth stocks over value stocks, leading to the inflation of bubbles that are bound to pop. Much like Hansen’s models, Shiller claimed that markets cannot be understood merely by rationality theory, and that analysts must acknowledge the psychology of investment risk and choice. He has famously called stock prices bad “weatherman,” irrationally influenced by its own hype.
Shiller predicted both the tech bubble in the 90s and the housing market crash of 2007.