By Allison Schrager
The 2013 Nobel Prize for economics celebrates that financial markets work, but cautions how little we know. One theme unifies the work of all three winners: Eugene Fama, Robert Shiller and Lars Hansen — risk. (A disclosure: until August I worked at Dimensional Fund Advisors, where Fama is a director and consultant.) Risk is unpredictable, but can be very profitable. That sounds simple enough, but it has profound implications — not only for the lords of high finance, but households, too. Risk teaches humility, to overconfident investors and also policymakers. That humility was notably absent at the IMF/World Bank meetings last week. Policymakers should take special note of the prize this year; it reveals how little we really understand about financial markets.
Fama's work showed that prices incorporate all available information; this is known as the efficient market hypothesis. The implication is that you cannot systematically outperform the market, unless you have information other people don't or can access part of the market others can't. But that doesn't mean you can't make money. Over time you can expect, but are not guaranteed, that riskier assets generate higher returns. Stocks, on average, return more than bonds because they are riskier. The stock of smaller companies is riskier than larger ones, so they typically generate more returns. It's a straightforward concept, but often poorly understood. Even many sophisticated investors get it wrong.
The implications of this theory changed markets, even for the average investor. The concept of efficient markets helped create demand for index funds. Index funds are a type of mutual fund, which is a collection of many different stocks. Active funds profess to know which stocks will outperform the market. Index funds don't make that promise; stocks are weighted by their size relative to the rest of the market or use a weighting based on identifiable price or size characteristics. Because there's no magic formula or talent presumed in constructing these funds, they are cheap; if no one can beat the market, why pay 1 or 2 percent of your assets to someone who claims they can? If you believe in efficient markets you'd only hold index funds. This has been revolutionary for the average investor. Through the 1960s few Americans owned stock at all, and if they did they only held a handful of individual stocks, which was very risky. Now about 50 percent of the population owns stock, mostly through mutual funds and increasingly with allocations based on indexing. The average household can invest as well as many hedge funds, for a fraction of the price. The existence of index funds shows that the best innovations (in finance or any industry) are often the simplest.
Fama's later work, and the work of the other new Nobelists, further refined our understanding of risk. Fama's more recent work helped us understand what kinds of risk investors are compensated for and how the return from risk varies over time and with economic conditions. Shiller's work showed that asset prices are more volatile than models would predict, but there may be some predictability to returns over long horizons. Shiller may be skeptical that asset prices accurately reflect all information, but he still believes markets work. He advocates more financial innovation, based on his ideas, including products that hedge housing price risk and swings in economic activity.
Hansen's work provided a way to measure how variables interact without presuming a perfect knowledge of how risky they are. His methods have been used in finance and macroeconomics. As the last five years have shown, financial risk has profound effects on the real economy. But how and through what channels is not well understood; macroeconomists often make unrealistic assumptions about risk or ignore it altogether. But even though Hansen pioneered new ways of using data to understand macro models of the economy and finance, he stresses we should not overestimate what we know.
What we learned from the recent Nobelists is that risk is very important; risk drives asset prices; risk changes over time; and we can't predict risk. One heard a different message at the IMF/World Bank meetings last week. There was little mention of financial market risk, other than uncertainty from the debt ceiling. Christine Lagarde insisted that the financial sector needs more policing and there was lots of excitement about "macro-prudential" policies — that is, where the central bank identifies areas of financial risk, decides it poses a danger and puts a stop to it.
Regulation is essential for any well-functioning market, but regulators must recognize their limitations. Risk rewards the people willing to tolerate it. That means some investors always crave risk; the harder it is to find, the more dear it becomes and the more people want it. The price of risk determines how capital is allocated; risky startups get the capital they need because they offer investors higher expected returns. The process is not always perfect, because investors might not be able to access certain markets or misconstrue information. But market-set asset prices convey more information than any alternative.
Some have interpreted the financial crisis as an indictment of efficient markets, but that view represents a misunderstanding of Fama's work. In order to reject efficient markets you'd have to believe that, before the crisis, it was possible to predict exactly what was wrong, where, by how much, and at the precisely right time. Even Shiller, who "predicted" the Internet and housing bubbles, hasn't always gotten the timing right. Indeed there were bad practices on Wall Street and many people underestimated the risks they'd taken. But if the bad actors in finance didn't know — and they had a fantastic profit motive to figure it out — how can we expect policymakers and regulators to know better?
The most effective and healthy regulation is transparent, simple and doesn't presume to perfectly manage risk. The more confusing and onerous the rules are, the more risk moves into the shadows and poses a greater threat. The Nobel prize this year validates how important, but limited, our understanding of finance is. As policymakers become more reliant on macro models of the economy, they'd be wise to keep that in mind.