Eugene F. Fama, Robert J. Shiller and Lars Peter Hansen shared the 2013 Nobel Prize in Economic Sciences for at times conflicting research on how financial markets work and assets such as stocks are priced.

The three economists, all Americans, “laid the foundation for the current understanding of asset prices,” the Royal Swedish Academy of Sciences, which selects the winner, said today in Stockholm. “It relies in part on fluctuations in risk and risk attitudes, and in part on behavioral biases and market frictions.”

Their work spans almost 50 years of research, beginning with the finding by the University of Chicago’s Fama that it’s difficult to predict price movements in the short run. That conclusion forms the basis for the theory that financial markets are efficient and led to the development of stock-index funds.

Later papers by Shiller and the University of Chicago’s Hansen focused on longer-run price swings and the extent to which they could be explained by such fundamental features as dividend payouts on stocks and the risk appetite of investors. Yale University’s Shiller, in particular, took issue with the argument that investors are always logical, using the phrase “irrational exuberance” to explain run-ups in asset prices...

While Kahneman was eventually awarded the economics ver­sion of the Nobel Prize for his work (Tversky had died), the findings of behavioural economics have long been viewed suspiciously by the mainstream. To efficient market purists, things like bubbles, or irrational behaviour, are inventions of people who don't understand the wisdom of the market. As Eugene Fama said in 2007, at the height of the US housing bubble, "economists are arrogant people. And be­cause they can't explain something, it becomes irrational ... The word 'bubble' drives me nuts."

4 Hours wrote:Disagree re: Fama, not necessarily the other guys. The EMH is bunk. Check out the following for a compelling analogy, the "Efficient Atmosphere Hypothesis":

http://physicsoffinance.blogspot.com/20 ... brium.html

Also, one of the heterodox economic books I read recently—towards which I have mixed feelings (see here: http://www.amazon.com/review/RDT0SXS4M5 ... nskepti-20) included the following telling excerpt:

While Kahneman was eventually awarded the economics ver­sion of the Nobel Prize for his work (Tversky had died), the findings of behavioural economics have long been viewed suspiciously by the mainstream. To efficient market purists, things like bubbles, or irrational behaviour, are inventions of people who don't understand the wisdom of the market. As Eugene Fama said in 2007, at the height of the US housing bubble, "economists are arrogant people. And be­cause they can't explain something, it becomes irrational ... The word 'bubble' drives me nuts."

What a tool. Seriously, what a frigging tool.

>yfw 25-standard deviation events in financial markets

Let's look at this in a little more detail. The Weak form of the EMH merely asserts that asset prices fluctuate in a random way so that there's no information in past prices which can be used to predict future prices. As it is, even this weak form appears to be definitively false if it is taken to apply to all asset prices. In their 1999 book A Non-random Walk Down Wall St, Andrew Lo and Craig MacKinley documented a host of predictable patterns in the movements of stocks and other assets. Many of these patterns disappeared after being discovered -- presumably because some market agents began trading on these strategies -- but there existence for a short time proves that markets have some predictability.

GT2211 wrote:-I don't agree necessarily that the findings of behavioral economists have been viewed with suspicion by the mainstream. That Kahneman won a Nobel is I think evidence of this.

The Weak form of the EMH merely asserts that asset prices fluctuate in a random way.

4 Hours wrote:

GT2211 wrote:-I don't agree necessarily that the findings of behavioral economists have been viewed with suspicion by the mainstream. That Kahneman won a Nobel is I think evidence of this.

Joseph Stiglitz won a Riksbankspris too. That doesn't mean the field as a whole has taken what got him the prize, namely his work on imperfect information to heart. Nor has it taken to heart any other deviant things he's said about things like globalization, including the Bretton Woods institutions. That's why he quit his office at the World Bank.

The Weak form of the EMH merely asserts that asset prices fluctuate in a random way.

"Random" needs clarification. Are you talking about Gaussian fluctuations in price?

And what happened to the part about the prices reflecting all available public information? The weak form sounds like saying that stock prices are somehow stochastic, which is not especially controversial and not, in the technical sense, necessarily a sign that markets are efficient.

The weak form of the efficient market hypothesis describes a market in which historical price data are efficiently digested and, therefore, are useless for predicting subsequent stock price changes. This is distinguished from a semistrong form under which all publicly available information is assumed to be fully discounted in current securities prices. Finally, the strong form describes a market in which not even those with privileged information can obtain superior investment results

Noah Smith wrote:First of all, people should realize that the EMH is misnamed - it's not really a hypothesis, it's not about "efficiency" in the economic sense of the word, and it's not unique (so it shouldn't have a "the" in front of it). Some of this miswording was just semantic clumsiness on the part of the people who came up with the theory. Some was sloppy science.

The "efficient" part of "EMH" doesn't mean that financial markets lead to a Pareto-efficient outcome. You could have externalities - for example, every time you make a financial transaction, God might kill a kitten - and the market could still be "efficient" in the way that financial economists use the term. Similarly, a vastly "inefficient" financial market might be Pareto efficient, since it might only be possible to make profits by taking advantage of someone else's stupidity.

The "efficient" actually just refers to information-processing efficiency. What that basically means is that if there's some piece of information out there - some fact about a company's balance sheets, or some pattern in past prices, etc. - the market price should reflect that piece of information. That's what "efficient" means here.

But exactly how should prices reflect information? Here's the bigger problem with the term "EMH" (the "sloppy science" part) - it's not really a hypothesis. How prices reflect information will always depend on people's preferences. In finance, preferences include preferences about risk. So without a measure of risk, it's impossible to scientifically test whether or not prices incorporate information. To be a real hypothesis, the EMH needs to be paired with a specification of risk (or, more generally, a hypothesis about people's preferences with respect to uncertainty and time, and a hypothesis about the sources of risk). And since there are many possible such specifications, there isn't just one "EMH"...there are infinite.

To complicate things, "the EMH" says nothing about how long it takes for the market to process information. So even if an EMH happens to be true at one frequency (say, daily), it might not be true at the 1-second frequency.

GT2211 wrote:Stiglitz work on information asymmetry is a major part of financial economics and RePEC's rankings based on influence/importance has him 4th.

GT2211 wrote:Someone else here may be more familiar with this than I am, but based on the interview below it does not seem that Fama believes that the EMH implies a bell curve type distribution.

To complicate things, "the EMH" says nothing about how long it takes for the market to process information.

4 Hours wrote:

GT2211 wrote:Stiglitz work on information asymmetry is a major part of financial economics and RePEC's rankings based on influence/importance has him 4th.

Who is implementing his ideas in practice? Certainly not his former employer.

GT2211 wrote:Someone else here may be more familiar with this than I am, but based on the interview below it does not seem that Fama believes that the EMH implies a bell curve type distribution.

Then how does he explain events well over four standard deviations, several times more than that in fact, occurring repeatedly on financial markets in the past decades?

To complicate things, "the EMH" says nothing about how long it takes for the market to process information.

That just allows the opportunity for endless ad hoc hypotheses to save the EMH.

But there's an even bigger problem with the EMH. A lot bigger:

Markets are efficient if and only if P = NP I don't think the author of the below

GT2211 wrote:wrong.

GT2211 wrote:He mentions in that link largely agreeing with Mandelbrot and Taleb on said events.

GT2211 wrote:I don't think it really needs saved. As Noah states in the preceding paragraph it is incomplete even as a hypothesis. Yet as an organizing principle it still provides use in terms of both generating insight and providing a starting point for the field behavioral finance which led to Shiller and Hansen's work.

GT2211 wrote:I'm not sure this is a bigger problem.