What Fama and Shiller Didn’t Teach Us About Finance

The contributions of Fama and Shiller are important but incomplete.

This morning, the Nobel Foundation awarded the memorial prize in economics to Eugene Fama, Lars Peter Hansen and Robert Shiller, and it struck some people as a bizarre act of self-negation.

Here's why: Fama is known for developing the theory of "efficient" markets after failing to develop trading signals for a professor while in college. His experience led him to the important insight that it is almost impossible for ordinary people to beat the markets, which later led to the introduction of low-fee index funds. Shiller, by contrast, focused on the ways thatfear and greed can lead to the mispricing of financial assets. He correctly warned that U.S. equities were expensive in the late 1990s, and that U.S. house prices were overvalued in the early to mid-2000s. (Hansen's contributions, while important, don't have the same practical applications for investors.)

Yet while Fama and Shiller may seem to offer contradictory insights, both men have more in common with each other than either does with the newer brand of finance researchers. That's because both economists agree that asset prices reflect investor expectations. Their disagreements boil down to differing views about the sources of those expectations.

For Fama, investors in the aggregate are "rational" -- they pay attention to the news and understand how new information affects the attractiveness of various assets. There may be plenty of dumb day-traders, but their activities ought to cancel each other out. Shiller, on the other hand, believes that expectations are shaped by experience. Nothing changes a man's opinion about the upside potential of the S&P 500 like watching his idiot neighbor get rich by buying Netscape shares after the initial public offering.

There is a newer generation of researchers, however, that recognizes the importance of expectations but also looks at other real-world factors determining asset prices, such as the structure of financial markets. Andrei Shleifer and Robert Vishny, wrote a crucial paper in 1997 explaining that smart traders can't bet against bubbles if they have to endure margin calls, for example. John Geanakoplos has focused on the ways that leveraged betting can increase the likelihood of extreme events that "shouldn't" occur if price changes are randomly distributed. Tobias Adrian, Emanuel Moench and Hyun Song Shin have shown that asset prices seem to be determined bythe willingness of investment banks and other financial firms to borrow, which in turnis affected by monetary policy.

What Fama and Shiller have in common, then, is having made contributions to our understanding of asset pricing for which regular investors should be thankful. But in our post-Great Recession world, policy makers, regulators and risk managers will probably be more indebted to the newer research with a firmer foot in the real world.

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