Understanding the Economics Nobel Prize 2013

1. Understanding theEconomics Nobel Prize 2013 Lasse Heje Pedersen

2. Economics Nobel 2013 The SverigesRiksbank Prize in Economic Sciences in Memory of Alfred Nobel 2013 was awarded jointly to Eugene Fama Lars Peter Hansen Robert Shiller “for their empirical analysis of asset prices” Lasse H. Pedersen

3. The Nobel Events October: the phone calls December: Swedish king awards the medal Gala dinner Lasse H. Pedersen

4. Market Efficiency Fight Inefficient! Efficient! “market efficient if prices always ‘`fully reflect’ ’available information I’m just testing.. NB: The “quotes” in this presentation are made up to illustrate the debate, they are not literal quotes See also Asness and Liew, “The Great Divide over Market Efficiency” http://www.institutionalinvestor.com/Article/3315202/Asset-Management-Equities/The-Great-Divide-over-Market-Efficiency.html

5. Market Efficiency: Random Walk? • Prices: , where k is a constant required return • Returns: i.e., random walk with drift k • Test: Stock split evidence looks like random walk • Event study methodology developed by Fama, Fisher, Jensen, and Roll (1969) • But “post earnings announcement drift” and drift in other events Lasse H. Pedersen

6. Prices Vary Too Much for Random Walk and Mean-Revert • Shiller: Excess volatility of market prices • Prices appear to bounce around more than earnings • Price-earnings ratio varies significantly (average = 16.5) Lasse H. Pedersen

7. Prices Vary Too Much for Random Walk and Mean-Revert • Dividend yield varies and high D/P appears to predict high future returns • Regressing yields Lasse H. Pedersen

8. If Not Random Walk, then What? • The expected return varies over time • Prices, where is a pricing kernel, e.g. • Returns or • Why does the expected return (i.e., the risk premium) vary? The Believer The “Atheist” The Agnostic • the risk premium is naturally high in recessions, plus its measured with error My GMM method can test this stuff. I reject standard consumption-based asset pricing models, but … No, it’s because people make mistakes and suffer behavioral biases low high low is messed up

9. Joint Hypothesis Problem • Joint hypothesis problem: • Any rejection of a model of the risk premium and market efficiency means • One of them is wrong, but not necessarily both • Rejection of the joint hypothesis means: The Believer The “Atheist” The Agnostic I can reject any model - but is it wrong in important or unimportant ways? the model of the risk premium is wrong and the market is efficient market efficiency is wrong Lasse H. Pedersen

10. Bubbles I called the internet bubble Relative to “post bubble”: Mkt went up 19% but underperformed Rf=30% December 3, 1996 Dude - you called it way early Lasse H. Pedersen

11. Bubbles I called the housing bubble Relative to “post bubble”: Prices went down ~7%, but must consider 9 years housing services and Rf = 17% Early 2003 Dude - you called it early again Lasse H. Pedersen

12. Bubbles You cannot trade on this “bubble” nonsense Dude – you trade on it every day with DFA Lasse H. Pedersen

13. Conclusion: Financial Economics Has Had Huge Real-World Impact • Market efficiency • Very useful idea with broad implications – cf. Darwin’s survival of the fittest • Focus on diversification and low fees • E.g., index funds • Behavioral finance • Focus on how people actually make decision • You can nudge people to make better decisions • E.g. by having a good default: save for retirement • Empirical tests • Decisions and knowledge should be based on rigorously tested facts • Important to understand data mining biases Lasse H. Pedersen