This year’s Nobel Prize in Economics was given to Eugene Fama (University of Chicago), Lars Peter Hansen (University of Chicago) and Robert Shiller (Yale University) for their work on understanding how asset prices are determined.
This academic research has had a profound impact on investment practice in the developed world, particularly in North America and Europe, and is currently having a growing impact in Australia and Asia.
The greatest influence came from Fama’s initial studies in the 1960’s and 1970’s demonstrating the difficulty in predicting individual stock returns over the short run.
Countless studies since the 1970’s have confirmed the difficulty in “stock picking’’ and shown that even professional portfolio managers of actively managed mutual funds that “stock pick” will on average not outperform the broad stock market index.
These findings have resulted in index funds and Exchange Traded Funds (ETFs) playing an increasingly important role in investment practice. These are funds that track a particular index or asset class.
By 2012, these funds accounted for over 40 per cent of the worldwide flows into mutual funds, with over US$3.6 trillion of assets under management.
The rising trend into these funds is likely to continue as more investors become aware of the benefits these funds offer in competitive risk adjusted returns with very low management fees.
In addition to the Nobel Laureates findings that in the short term, stock return predictability is very limited, they also provided profound insights into the longer term predictability of asset returns.
Over medium term horizons such as five years, they demonstrated substantial predictability in asset markets such as stock markets and housing markets.
Robert Shiller’s 1980’s work in this area has been particularly influential and popularized in his bestselling investment classic entitled “Irrational Exuberance”. Shiller demonstrated that over longer horizons, stock markets and housing markets are predictable based on fundamentals such as firm earnings for stock valuations and household incomes for housing valuations.
However, over shorter horizons asset prices are prone to “fads’’ and overreaction to changes in fundamentals. Shiller has shown remarkable ability to identify bubbles in asset prices before they burst. This includes the bubbles in the stock market in the 1990’s and housing markets around the world before the recent global financial crisis.
After winning the Nobel prize, Shiller warned that there are still many housing markets looking bubbly, including Australia. Hansen’s most influential contribution has been the development of a statistical method that has proved extremely useful in empirically evaluating asset prices.
Overall, these three economists have shaped the way asset prices are interpreted and how investment portfolios are constructed. In addition, they have provided important insights into the risk involved in investing in asset markets.
Dr Jonathan Reeves is a financial economist at the Australian School of Business, UNSW Australia.
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