October 14, 2013

The Royal Swedish Academy of Sciences announced today the winners of the Nobel prize for economics—Americans Eugene Fama, Lars Peter Hansen, and Robert Shiller. The men were awarded the prize for developing methods for studying how prices for assets are arrived at, including stocks and houses.

Eugene Fama, of the University of Chicago, is famous for his “efficient markets hypothesis.” In Fama’s view, markets are good at incorporating new information into the prices of an asset, such as stocks and bonds. Because of this efficiency in markets, Fama believes investors have little opportunity to effectively pick stocks in which to invest and would do better simply investing in a mututal fund based upon a stock index—for example, the Standard & Poor’s 500, which is an index of the stocks of 500 large companies trading on the New York Stock Exchange.

In some ways, Robert Shiller, of Yale University, takes somewhat of the opposite view to that of Fama. Shiller belongs to the school of behavioral economics that studies human psychology and decision making and its effects on economics and finance. Shiller believes markets are not always efficient or rational and that assets can be mispriced for lengthy periods of time. In his book Irrational Exuberance (2000), Schiller claimed that stocks were in a bubble (priced too high) based on enthusiasm for dot-com businesses. Soon after, the stock market fell precipitously. Shiller also predicted in the mid-2000′s that the housing market was in an irrational bubble. Steeply falling housing prices were one piece of the Great Recession that began in 2007 and continued into 2009.

Lars Peter Hansen, also of the University of Chicago, created statistical methods to understand what drives the volatile and irrational prices for assets. His work determined that prices are sometimes linked to how much risk people are willing to accept, rather than on such real-world events as profits and rents. During good times, people are less averse to risk; in bad times, they are far more cautious.

Additional World Book articles:

• Economic Crisis: The Banking Meltdown (a special report)
•  Economic Crisis: The Government Steps In (a special report)