What We Know and What We Believe

Three Points of View Reflected in Nobel Prize in Economic Sciences in 2013, and Why this Matters to You

This year, the Nobel Prize committee showed that they have a sense of humor when they awarded the prize to three economists who have rather different points of view, and who themselves had to chuckle at the idea that they were sharing it. One wag compared this to sharing the award between Ptolemy for proving the earth is at the center of the universe and Copernicus for proving that it isn’t!

Much of the work of these three is very technical and not something we would attempt to discuss here, but their points of view are interesting and important and have practical implications as well. At the end we cite a number of articles discussing the prize and their views and we think spending a few minutes looking over a couple of them might be very useful and interesting for you. Meanwhile, we will focus on a few key points and practical implications for you.

 

Why are we writing to you about this?

In other words, who cares? Isn’t this just another obscure academic debate, highly technical, trivial, of little relevance to us in our day-to-day lives?

Well, in a word: No.

Oddly enough, these three men agree on what the data says. Unlike the earth/sun debate, we are past the point where the data resolves the issue. We can summarize this in surprisingly simple terms; when you define markets properly and look at long-term outcomes for diversified portfolios of equities:

1.   There is very little evidence that active management and market timing outperform “the market” despite extensive studies looking for that evidence. There is a lot of evidence that active management, by and large, does not work.

2.  Value stocks have a higher return than growth stocks.

3.  Small stocks have a higher return than large stocks.

Where the happy consensus breaks down is over the question of why markets work this way. Are markets efficient or are irrational forces at work? Can one outperform the markets by taking advantage of irrational behaviors? Are there “bubbles” in asset pricing, such as the technology stock “bubble” in the late ‘90s and the real estate “bubble” that burst in 2007? The answers to these questions can result in very different approaches to everything from investing to government regulation.

 

OK, so who are these people and what do they say and do?

1.  Eugene Fama from the University of Chicago
2.  Lars Peter Hansen also from the University of Chicago
3.  Robert Shiller from Yale

2013 Nobel Laureates
(L-R) Eugene Fama, Lars Peter Hansen and Robert Shiller

As anyone reading our communications will recall, Professor Fama is the intellectual godfather (and board member) of Dimensional Fund Advisors ( DFA), the family of low-cost, passive funds that seek to capture the returns of the markets plus value and small size, the three factors that the data show have contributed to the returns of long-term portfolios of equities. DFA has become extremely successful, as their funds have delivered the returns of these factors over several decades. Today, they manage about $300 billion, and the University of Chicago Booth School of Business, where much of this work was done, is now named for David Booth, a student of Professor Fama who founded DFA in 1981.

Professor Fama is also known as the father of efficient markets, which is where he parts company with his fellow prize winners. His point of view is often mischaracterized as the belief that every individual investor is objective and rational and acts intelligently in buying and selling securities. It is more accurate to say that Professor Fama says that he sticks to what he knows, the evidence we cited above, and in the absence of proof that other forces are at work, the simplest view is that markets are generally efficient in the sense that it seems to be extremely difficult to consistently outguess them and come out with better returns and/or reduced risk.

Professor Hansen lies somewhere in between Professors Fama and Shiller, and is most appreciated for his development of a statistical technique, a model that is widely used in a variety of fields now. This model can be used to address the core issue of irrationality as a causative factor in market pricing and volatility. As he points out, merely asserting irrationality is insufficient; you have to develop and test new ideas and explanations. I will leave it there for now.

Professor Shiller is actually pretty famous; he writes frequently for the New York Times and appears in various media arguing that markets are often irrational, although he grudgingly says that yes, he might even suggest investing in DFA funds, despite his disagreements with Professor Fama. He speaks frequently about behavioral finance, a body of research that does indeed demonstrate that people behave irrationally in a variety of ways related to investments.

Active vs Passive Investing

What’s the bottom line – what difference does this make to me?

The interesting part here is that the disagreement is mostly about the “why” questions and not about the “what”. The “what” part is the overwhelming evidence that investors trying to outperform markets fail, and that disciplined investing in the equity markets passively, with extra value and small size exposure, and keeping costs low, is a winning strategy. We know that this has been historically true, which is no guarantee of future performance, of course, but in this case the evidence provides a solid basis for believing that it will continue to work this way going forward.1

The “why” part gets more deeply into what we believe. Professor Fama points out that we can’t prove this part; we don’t know with certainty what drives markets to behave the way they do. Thus, the assumption that prices are relatively efficient, and hard to outguess. Efficient markets, in other words.

Professor Shiller believes strongly that irrationality drives markets in a variety of ways. And he asserts that we ought to be able to beat the market if we are really smart (like him) and understand these behavioral things well, although he agrees that trying this is a bad idea for most investors. He also believes market problems like the 2008 meltdown are primarily the result of lack of regulation. He can point to the evidence that irrationality exists (behavioral finance providing a lot of it)—we can know that. But, so far he can’t prove that the irrationality is the driver of the markets and pricing and volatility; he can, for now, only believe it. Meanwhile, Professor Hansen has provided the world with a powerful tool to help search for answers to these questions, and I am sure you will all be on the edge of your seats waiting to hear the latest developments in this field. We certainly will.

In Conclusion

The good news is that, based upon what we know, supported by the evidence provided by all of these academics and many more, markets generally work well. After all the volatility, and despite their unpredictability and many mishaps, markets have continued to deliver the kind of long-term, real returns (after inflation) that we expect to receive as compensation for accepting the risk.

We, the investors, don’t need to wait for the ultimate answers on what drives market outcomes; those answers may not be found in our lifetimes anyway. We can leave the arguments about “why” to the PhDs and base our strategies on what we do know. And that is really good news.

 

More Information on the Nobel Prize-Winning Economists

New York Times: Eugene Fama, King of Predictable Markets

New York Times: Shiller vs. Fama vs. the Skeptics

Bloomberg:  Nobel Prize Shows Both Wisdom and Madness of Crowds

Eugene Fama Awarded Nobel Prize in Economics (Video from DFA)

 

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Roger Hewins
Roger Hewins

President

Roger Hewins is the President of Hewins Financial Advisors. Roger has more than 30 years of experience in investment management, helping bring the sophisticated financial advice typically reserved for large institutional clients to everyday investors, from high-net-worth individuals and families to small businesses and retirement plans.

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What We Know and What We Believe

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