And the Nobel Prize in Economics goes to polar opposites

Believe in efficient markets? Or favour behavioural finance? You win either way

Tue, Oct 15, 2013, 01:08

At first glance it is tempting to laugh at the 2013 Nobel Prize in Economics being shared between an academic who invented the “efficient markets hypothesis” (Eugene Fama) and another who has spent much of his career demolishing that very same idea (Robert Shiller). Every prejudice and joke about economists seems to be encapsulated by this year’s award.

Academics have been quick to rush to the defence of the prizegivers: it is a tough circle to square but there have already been many valiant attempts by friends and colleagues of the recipients to suggest that it isn’t as daft as it seems. There will inevitably be a lot of questions raised by the award to Fama: some economists never quite recovered from the fact that he was overlooked in 2010 in favour of Paul Krugman.

That the financial world was, in its post-Lehman funk, providing yet another example of market irrationality didn’t seem to matter in the closed monastery that is much of academic economics.

Efficient vs correct
Getting to grips with all of this is not easy. It all depends what you mean by “efficient”. Few quibble with the notion that markets are very quick to absorb new information and are very tough to beat. But the theorists often go on to make less plausible claims, sometimes in very slippery ways. In particular, if by “efficient” we also mean “correct”, then that is an intellectual stretch too far.

Stock and bond prices may indeed incorporate all current information and be next to impossible to forecast, but this does not imply that their prices are, therefore, always and everywhere the right ones. For practitioners and anyone who just glances at the wild gyrations of markets for things like company equities and foreign exchange, it is blindingly obvious that prices are as wrong as often as they are correct.

Shiller is a pioneer of “behavioural finance”, a field which tries to explain why markets behave as they do. He has explored many different ways in which asset prices can behave strangely – he wrote a famous book called Irrational Exuberance. To be fair, Fama has also made a massive contribution to the study of markets – but nearly always in an attempt to prove the original ideas of efficiency and rationality. I say “nearly” because Fama, paradoxically, has also produced hugely important studies (with Kenneth French) of the oddities of small companies and value stocks: disciplined and skilled investors seem to be able to make money investing in these kinds of companies, in flat contradiction of the principles of market efficiency. Fama, inevitably, tries to rescue his original ideas, but in ways that few behavioural theorists find plausible.

A hatred for disorder
Economists like things to be ordered; they hate mess.

Typically, they don’t like behavioural finance. Fama has said, “I don’t know what asset pricing would look like in a world that really took behavioural finance seriously . . . if you really think prices are incorrect, what are you going to tell me about the cost of capital?”

That last comment is telling: one of the reasons why the idea of efficient markets (and its sister, the capital asset pricing model) exercises such a hold on the economics profession is that it provides precise answers.

Richard Thaler is another leading behaviourist and has said about all of this “ . . . because human nature is a mess . . . it’s a choice between being precisely wrong or vaguely right”. This is spot on: efficient markets theory risks spurious precision; behavioural finance is as messy as the real world.

Merton Miller, another giant of the efficiency school, put it this way: “there’s only one theory of efficient markets, there are hundreds of theories of inefficient markets”.

Maybe it is a little unfair to poke too much fun at the obvious contradictions implicit in this year’s Nobel Prize. There is clearly a hope that the two approaches to asset price determination can somehow be brought together in a new “theory of everything”. I suspect we may be waiting some time.