Hand-wringing over Nobel Prize in economics

This year’s Nobel Prize in economics went to Eugene Fama, Robert Shiller, and Lars Hansen, leading to much hand-wringing over the apparent conflicts between the work of Fama and Shiller (Hansen is mostly known for research on risk, which may be why so few are discussing him).

Fama is famous for the efficient markets hypothesis, which posits that securities prices reflect all available information, which on the face of it makes quite a contrast to Shiller’s central assertion that animal spirits — greed and fear — drive financial markets and make bubbles a regular feature.

First off, economics is a social science, not a hard science, so do not kid yourself that anyone has the final word on anything.

That said, there is much of use in both men’s work, and employing a strategy often used by Nassim Nicholas Taleb, perhaps we can boil it down to the following rules of thumb: Regulators and central bankers ought, in general, to behave as if they believe Shiller, while investors, by and large, will be far better off if they heed the lessons of Fama.

If both those rules of thumb had been followed the past 20 years, you, dear reader, would likely be living in a society with greater economic output and less-damaging economic volatility, while looking forward to a more secure retirement due to having more in savings.

Remember Citigroup chief Chuck Prince’s comment, just before the crash, about how you have to dance while the music is playing? That was an acknowledgement of how commercial pressures (and personal gain) prompt banks to keep pouring on credit, even when things appear to be getting out of hand. That this happens is something well understood by Shiller.

Perhaps Fama’s biggest contribution to the happiness and sanity, not to mention wealth, of the average investor is in providing the intellectual underpinnings for the growth of the index fund movement.

“Research generally has failed to find that mutual funds generate positive returns above what can be motivated by the level of risk; once fund fees are taken into account, their asset management often yields negative excess returns,” according to a statement from the Swedish Royal Institute of Sciences, which chose the winners.

“The recent growth of index funds, which collect all stocks in passively managed portfolios, follows that insight.”

Markets, Fama’s work in the 1960s tried to show, were the distillation of all available information, making predicting their future movements essentially pointless. The takeaway, as far as you and I are concerned, is that markets are efficient enough, enough of the time, to make it not worth your while to indulge in active management.

A 2010 paper Fama authored with Kenneth French of Dartmouth, found that just 3% of mutual fund managers demonstrated meaningful skill, about the same number as would be produced by chance.

Three out of 100 does not look like very good odds to me, and so most people, in most circumstances, should lean heavily on index funds for their investments.