Trends, No Trends, and Statistics

No skein of work in economics has been so heavily written about by high-end journalists over the years as the developments that are the subject of this year’s Nobel Prize. Asset pricing is not my thing, but I’ve been reading about it ever since 1967. That was when The Money Game, by “Adam Smith” (who turned out to be magazine writer George Goodman, later a member of the editorial board of The New York Times) brought the New Journalism (Scarsdale Fats, Odd-Lot Robert and the Gnome of Zurich!!!) to the formerly genteel world of writing about finance.

Goodman’s best-seller appeared just two years after 25-year-old Eugene Fama, in Chicago, and Paul Samuelson, 60, in Cambridge, laid the cornerstone of the academic debate about personal investing – random walks, efficient markets and dart board funds. A great deal has happened since then.  It’s been well-covered every step of the way.

There’s an art to putting together a really good Nobel Prize in the economic sciences. You want a field in which most people are interested. You want work that has made a demonstrable difference in the way the phenomenon is understood. And you want laureates who will be good public personalities.  The people who put this together this year’s award did a great job.  Not since Robert Aumann and Thomas Schelling shared the prize, in 2005, has a field been so attractively illuminated by the juxtaposition of its leading personalities. (careless writing subsequently improved)

Thus Fama, 74, of the University of Chicago’s Booth School of Business, is fiercely loyal to his roots. The  grandson of Sicilian immigrants to Boston, he married his high school sweetheart at Malden Catholic High School (they’re still married), and had the good fortune to be put to work by Tufts College professor Harry Ernst devising schemes for his stock market forecasting service. When none of those he invented worked, Fama’s curiosity was piqued. Half his 1964 thesis at the University of Chicago investigated whether it was generally possible to beat the stock market; the second half demonstrated that it would be worth it if you could, since returns to some stocks in a large sample were inevitably more extreme than a normal distribution would lead you to expect.

The first half of that thesis quickly became the surprising “efficient markets hypothesis,” the proposition that the market was hard to beat (and virtually impossible to fool) because it quickly incorporated all available information — its behavior resembled the random walk of, say, a drunken sailor; no reliable trends werre to be discerned.  The second half, after 1981, became Dimensional Fund Advisers, the money management firm that Fama’s students founded to take advantage of the implications of various aspects (dimensions) of risk  that Fama and others had identified. A couple of  decades later, Dimensional co-founder David Booth donated $300 million to Chicago’s Graduate School of Business, where he had learned his trade, hence the Booth School of Business. (Fama remains on the DFA board.) For many years Fama was thought by some to have been too bold in his early claims for market efficiency to ever win the blessing of the Swedes; the passage of nearly half a century removed those doubts.  Here is his son-in-law, John Cochrane, on the prize.

Then there is Robert Shiller, 67, of Yale University, who came at the problem from the opposite end. A student of Franco Modigliani at the Massachusetts Institute of Technology (as Fama had studied under Modigliani’s co-author, Nobel laureate Merton Miller of Chicago’s Booth School), Shiller once described the efficient markets hypothesis as “one of the most remarkable errors in the history of economic thought.” It was mass psychology that often moved markets instead. In the early 1980 Shiller demonstrated convincingly that stock prices were more volatile than their underlying dividends, and that money could be made by trading on certain patterns among them.

Soon many traders and economists, having identified one anomaly or another, started hedge funds to take advantage of them.  Many fortunes were made.  Shiller  himself espoused “macromarkets,” experimental derivative markets in which individuals could hedge against such risks to their income as unemployment and slow growth.  He partnered with Wellesley College’s Karl “Chip” Case, who devised an index of basic home prices in markets around the country that turned out to be useful in many ways. The era of behavioral finance had arrived. And in Irrational Exuberance, in 2000, and again in Animal Spirits: How Human Psycology Drives the Economy, and Why it Matters for Global Capitalism, with Nobel laureate George Akerlof, in 2009, Shiller argued that asset price bubbles could be identified with relatively simple tools such as price-earnings ratios and deflated without lasting harm. Says Fama, “I don’t even know what bubble means.” How can such opposed views be squared with getting the prize?  It’s up to future  laureates to narrow the difference; something more than a split-the-difference blend surely will be requited.

Lars Peter Hansen, 60, of the University of Chicago economics department, as  self-effacing as the other two laureates are bold.  An intense but personable econometrician, Hansen was cited for having developed the generalized method of moments, a means of estimating parameters of the statistical models with which asset-pricing theories are tested. Here’s the best explanation I came across. And here’s a beguiling post by one of Hansen’s brothers.   And while Hansen is all but invisible compared to his fellow laureates, he is the one who, since 1999, has been a member of the National Academy of Sciences.

After hitting the jackpot with The Money Game in the Go-Go years of the 1960s, Goodman followed up with Supermoney, in 1972, but already his focus had begun to shift away from developments in finance toward macroeconomic concerns (equities were in the doldrums anyway), and, with Paper Money (1981), still further. It mattered less, since the glossy fanzine Institutional Investor had appeared in 1967, offering lucid monthly journalism, accompanied by expensive art,  designed to keep professional money managers abreast of the new investment technologies. And in 1973 Princeton University economist Burton Malkiel, in A Random Walk Down Wall Street, explained the new ideas about market efficiency to a broad audience of individual investors.  Forty years and ten editions later, the book is still in print.

By 1991, author Peter Bernstein had put aside his chores as founding editor of the Journal of Portfolio Management to write Capital Ideas: The Improbable Origins of Modern Wall Street  The book appeared just in time to interpret the series of Nobel Prizes that had begun to arrive:  Harry Markowitz, Merton Miller and William Sharpe the year before;  Robert C. Merton and Myron Scholes in 1997. (Scholes’ collaborator Fischer Black died in 1995); Kahneman and Vernon Smith in 2002 (Kahneman’s collaborator, Amos Tversky, died in 1996).  By then, events were moving fast enough that Bernstein added Capital Ideas Evolving in 2007.

In 2009, Justin Fox, of Fortune magazine, came down on Shiller’s side of the argument with The Myth of the Rational Market:  A History of Risk, Reward, and Delusion on Wall Street.  There were plenty of war stories but not enough focus for the book to truly succeed. The same with John Cassidy, of The New Yorker, with How Markets Fail: The Logic of Economic Calamities in the same year.  (Here are Fox and Cassidy on this year’s Nobel.)  The following year, Sebastian Mallaby, for many years of The Economist, zeroed in on the central developments in More Money than God: Hedge Funds and the Making of a New Elite.  Finance professors had become eager to test the limits of market efficiency, he wrote, especially after 1987, when the market’s valuation dropped by a fifth in a single day; but it was really when pension funds and university endowments began to entrust money to the  hedgies in hopes of bettering the market that the latest experiment took off. (The results so far appear to favor relative market efficiency:  low-hanging fruit, once identified, quickly disappears.)

And when the Annual Review of Financial Economics appeared in 2009, volume one led off with “An Enjoyable Life Puzzling Over Modern Finance Theory,” by Paul Samuelson;  “Portfolio Theory, As I Still See It,” by Harry Markowitz, appeared in volume two;  and “My Life in Finance,” by Fama, in volume three. An article about Fischer Black, by Robert Merton and Myron Scholes, appears in volume five.

Part of the charm of the efficient markets story is the way it migrate out of economics departments at both Chicago and MIT and into the real world. After David Henderson, of the Naval Postgraduate School, credited Fama with having inspired the launch by Vanguard of passively-managed index funds, Vanguard founder John Bogle wrote The Wall Street Journal to say that ten years passed before he even heard of Fama.  It was MIT’s  Samuelson who stoked his intuition that an index fund of the shares of 500 representative companies would routinely outperform all must a few mutual funds, thanks mainly to its lower turnover costs and selling expenses.   He contrasted his pragmatic “cost matters hypothesis” with more theoretical alternative that animates Dimensional’s search for persistent undervaluation off various market segments.  The Nobel committee noted that passively managed funds now account for more than 40 per4cent of the flow into mutual funds, or $3.6 trillion, up from zero before the efficient markets controversy began.

This year’s prize illuminates, too,  the usual penumbra of those just outside of the spotlight:  Kenneth French, of Dartmouth College Tuck School of Business, Fama’s long-time research partner;  behavioral economics theorist Richard Thaler, of the University of Chicago’s Booth School; Stephen Ross, of MIT, the author of a landmark paper arbitrage pricing theory in 1976; and Benoit Mandelbrot, the peripatetic mathematician who died in 2010.  In The Fractalist: Memoir of a Scientific Maverick, Mandelbrot left behind a charming story about how he and Fama competed for the same job at the University of Chicago in 1964. Fama won, through single-minded dedication to the economics faculty, and Mandelbrot, forever restless, moved on to IBM, Harvard, MIT, and his place in history as the father of fractal geometry.  You can read the detailed Nobel asset-pricing citation here.  Myself, I plan to wait for the next wave of high-end journalism.

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