When you mention "Chicago" in the world of economics, people in the know think of University of Chicago finance professor Eugene Fama. He’s rigorous, blunt and unconcerned about what anyone else might think of the free-market ideas that make him the living embodiment of the traditional "Chicago School" of economics.
Fama won the 2013 Nobel Prize for economics on Monday, along with University of Chicago colleague Lars Peter Hansen and Yale University’s Robert Shiller. The only surprise about Fama winning the Nobel is that it took so long.
Fama, 74, is best known for a theory he developed in the 1960s and 1970s that is simple to express, which has made it all the more controversial: Markets are efficient. They are accurate. They take into account all available information at all times. Whatever investors know about a stock or bond is already reflected in its price, and prices respond instantly to newly available information. As a consequence, no one will consistently beat the market.
Under Fama’s efficient-market hypothesis, even professional portfolio managers won’t beat the market in the long term because of their expertise, and those who believe they can are deluded. This is not a hypothesis that’s popular with the mutual-fund managers who command big fees from customers who believe they can gain an edge.
Fama once hesitated to compare such stock-pickers to astrologers for fear, he said, of insulting astrologers. One of his most recent papers was partly titled, "Luck Versus Skill," and it exhaustively set out to prove that no active money managers have "enough skill to cover the costs they impose on investors." The market is a zero-sum game, and if certain managers outperform for a time, their less-lucky rivals earn less, with the overall gains sharply reduced by fees and other expenses.
If this theory sounds like it was dreamed up by an academic, consider that Fama also is the big-thinker behind Dimensional Fund Advisors, a successful investment firm that puts his ideas into practice by eschewing stock-picking, market-timing or any other effort to beat the averages. Its co-founder, David Booth, is a Chicago business-school grad who gave his alma mater a $300 million donation in 2008, saying that he owed his success to Fama. The school is now known as the University of Chicago Booth School of Business.
Not everyone subscribes to Fama’s ideas. Far more money is invested in actively managed mutual funds, for instance, than in the passive index funds that would be the better bet if Fama is correct. Fama is sharing his Nobel with fellow Chicagoan Hansen, who developed statistical techniques to analyze economic models, and with Yale’s Shiller, whose ideas in many ways contradict Fama’s.
Shiller believes that markets are less than rational, reflecting the flawed individuals who trade them. Humans overreact. They get emotional. When times are good, they behave with "irrational exuberance" — also the title of a well-received book Shiller published in 2000 that foreshadowed the boom and bust in stock and housing markets. Shiller is known for developing the widely cited Case-Shiller index of home prices.
Considering the volatility during and after the Great Recession, Shiller’s theories would seem to have common sense on their side: After that roller-coaster experience, no one could doubt that market "bubbles" are real, or that emotions affect market activity, right? Wrong, says Fama, who backs up his assertions with enough data models to launch a spacecraft.
Some observers have suggested that Shiller and Fama have more in common than meets the eye. Nobel laureate economist Robert Solow knows better: Awarding the prize to Fama and Shiller, he noted archly, is like giving it to the Yankees and the Red Sox.
The Nobel decision may strike some as Solomonic. It will remind others of Harry Truman’s famous plea to send him a one-armed economist, because he was tired of "on one hand, on the other" experts who hedged their predictions.
But that’s the Nobel committee having it both ways. The economists it recognized Monday are quite the antithesis of the timid experts who drove Truman crazy.
These new Nobel laureates helped to build the foundation for understanding asset prices. Plenty of insights are yet to come. Past performance is an indicator that more will come from Chicago.