Three Americans were awarded the Nobel prize in economics Monday for work that helped answer this crucial question: What determines the prices of an asset, whether a stock, bond or a house?
The winners of the $1.23 million prize were Eugene Fama and Lars Peter Hansen of the University of Chicago and Robert Shiller of Yale. Their work has led to everything from low-fee index mutual funds to a deeper understanding of why home prices can become irrationally high, as they did in the last decade. Fama and Shiller are considered direct opposites in their views of how markets sort out the prices of financial assets. Fama, 74, is a father of the "efficient markets hypothesis," the idea that because markets are very good at incorporating all known information about the value of an asset, it can be a fool's errand to try to predict in what direction the price of a stock or bond will go. Shiller is a leading proponent of the idea that markets, driven as they are by human psychology, can create large and sustained mispricings, such as in the late 1990s when excessive optimism drove the stock market into bubble territory. He is a student of "behavioral economics," the study of how quirks in human psychology can create results that traditional economic theory would not predict.
With the joint award, the Nobel committee was in effect fusing those competing schools of thought into a unified theory to recognize what economists now understand about where asset prices come from.
"The Laureates have laid the foundation for the current understanding of asset prices," the committee said in its announcement of the prize, formally known as the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. "It relies in part on fluctuations in risk and risk attitudes, and in part on behavioral biases and market frictions."
Fama's research is fundamental to modern finance theory, though his work has been tarnished some in recent years by wild swings in financial markets that have suggested they are anything but rational. His seminal paper "Random Walks in Stock Market Prices," from 1965, is part of a body of work that casts doubt on any theory that we can predict the future value of a stock or bond merely by looking at a price history chart. His work showed instead that the movement of an asset price is a "random walk" in which the price rises or falls based on new information (say, word of a company's sales, or the future direction of interest rates) and that this information is immediately incorporated into and asset's price.