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It's the Data, Stupid!

Empiricists grab this year's Nobel Prizes.

John Rekenthaler, 10/17/2013

Hearing the Other Side: Part 1
The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, to give the award its full and awkward name, is generally given to theorists. The first finance winners--Markowitz, Miller, and Sharpe in 1990--were honored for building models, not for sifting through data. The same held true for the next honorees--Merton and Scholes in 1997--for their work on derivatives pricing. Kahneman and Smith, the 2002 Nobel winners, did conduct empirical tests, but those were mostly laboratory experiments, not collecting and analyzing security prices.

This year's awards, given to Eugene Fama, Robert Shiller, and Lars Peter Hansen, broke the mold. All three researchers are steeped in the data analysis of investments.

It's no exaggeration to write that Professor Fama's career was built on his ability to extract insights from large data sets. Among Fama's successes has been his careful, thorough analysis of several decades of U.S. stock market results, conducted with Ken French, which led to the groundbreaking conclusion that stocks have not in fact behaved as predicted by Professor Sharpe's capital-asset pricing model.

At least Fama's efforts have largely come while defending a positive thesis, that stock markets are efficient. In contrast, Professor Shiller has used data to negate existing beliefs. Throughout his career, Shiller has poked at academic theories of how assets are priced. For example, if stock prices are determined by the discounted value of their future dividends, then how to explain market crashes? Future dividend values do not change overnight. Nor should there be much movement in the discount rate in such a short time period.

For Shiller, asset prices are not consistently rational, despite the academic community's best efforts to argue otherwise. This holds true for residential real estate as well as for stocks. At times, Shiller has described each of those markets as being in the midst of a "bubble," or suffering from "irrational exuberance." Whether Shiller's insights can be profitably applied remains to be seen, but they most certainly are intended as such. Shiller thinks and talks like an investor. In that, he differs greatly from his predecessors.

(Of the final 2013 winner, Professor Hansen, I can say little. His work is specialized and technical. But Hansen, too, has been an anti-theorist, developing statistical tools to demonstrate that standard models of stock market volatility fail at the task. As Shiller argues--although from a different perspective and using a different data set--stock prices fluctuate more widely than can be explained by the conventional assumptions of investor rationality.)

The Nobel committee's decisions reflect the evolution of financial theory.

In the early days, the aim was to develop a single, straightforward model for each major investment item. Thus, Harry Markowitz's framework of the "efficient frontier," using as inputs an asset's forecasted returns, volatility, and correlations, would address the topic of asset allocation. Similarly, Bill Sharpe's capital-asset pricing model would serve to explain stock prices, as well as extend asset-allocation theory by a) demonstrating the usefulness of owning an entire marketplace of securities (as opposed to a mere subset) and b) incorporating leverage. 

is vice president of research for Morningstar.

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