This morning, the Royal Swedish Academy of Sciences honored three Americans with the most prestigious award in Economics: the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (more commonly known as the “Nobel Prize”). The honorees, Dr. Eugene Fama, Dr. Lars Peter Hansen, and Dr. Robert Shiller, received this award “for their empirical analysis of asset prices.” Although these three scholars are sharing the prize of 8 million Swedish Krona (roughly $1.24 million), their research programs are quite divergent, and at times even contradictory.
Among Dr. Fama’s most noted work is his defense of the Efficient Markets Hypothesis (EMH). In several seminal papers (e.g. here), Dr. Fama used statistical analysis to argue that markets automatically and rapidly incorporate all available and relevant information into stock prices, thereby eliminating the ability for investors to earn abnormal returns consistently (i.e. to beat the market on a risk-adjusted basis). Dr. Shiller, in contrast, challenged the rational-investor assumption that underlies the EMH. Most notably, in his seminal 1981 article (see here), Dr. Shiller demonstrated that stock market prices fluctuated much more wildly than did the related companies’ dividends. Dr. Shiller’s findings challenge the mainstream valuation approach that is based on the assertion that an asset’s value is equal to the present value of its future cash flows (i.e. dividends). The wild fluctuations in stock prices, Dr. Shiller maintains, are in fact due to irrational behavior among investors. This same irrationality is supposedly responsible for the boom and bust of the most recent housing bubble. As further evidence of these researchers’ independence, the third Nobel recipient, Dr. Hansen, conducted research that is largely orthogonal to asset pricing. The major contribution for which he is honored is a statistical technique called the Generalized Method of Moments (see here) which is used extensively throughout economics and other social sciences, including the study of financial markets. In spite of their differences, these three scholars generated significant progress in our understanding of how risky assets (e.g. stocks, bonds) are priced by financial markets.