Fama for the Nobel?

Greg Mankiw reports that Eugene Fama is, according to a betting agency, the favourite to win the Nobel Prize for economics this year.

If this were a prediction market rather than an old-school betting agency, I would be heavily short on this contract - I just don't think this is likely. Not because I don't think Fama is an excellent candidate and thoroughly deserving of a Nobel - he is basically the father of modern finance. However, Nobels measure largely the influence someone has had on their profession - and since the financial crisis I think it's safe to say that Fama's Efficient-Market Hypothesis is not at the peak of its popularity (although I am still a fan). For that reason, Fama would be a pretty controversial pick.

The same reasoning applies to Kenneth French, who is also quite high up.

Who will win it then? I don't know. I'm also sceptical of Paul Romer (who is just behind Fama on the odds), so my bet would be with Ernst Fehr, whose work on behavioural finance and neuroeconomics is looking pretty good about now.

That said, I hope to be proven wrong and see Fama win, I think he's awesome. Here's an interesting video interview with him about his life.

Luck, Size, and the NZ Super

In light of recent substantial budget deficits and worsening outlooks, the NZ Government has cancelled contributions to the NZ Super fund in the medium term. The Super Fund is an investment fund whose board of directors reports to the Government, and up until the financial crisis it had made above-market returns, but now is (I believe) slightly below par. It was intended to cover some of the cost of superannuation in the future.

Unfortunately, the debate around the cessation of payments has caused some recurrent fallacies about financial investment to, uh, recur. Unsurprisingly this is most common at the moment among those who support the parties in opposition, but I suspect that the same fallacies are broadly shared irrespective of political affiliation.

The first is that it is possible to consistently 'beat the market'. Share prices, we are told, are really low at the moment, and so if we buy them all now (or the Super Fund buys them on our behalf), when they go back up again we will all be rich. It would be fabulous if it were as simple as buying low, selling high. It supports our basic intuitions about trends - things usually carry on in the same direction if they have been doing so for a long time. Population increases, economic growth increases, so on. But this intuition fails us when it comes to financial markets.

To find out why, we have to turn to the Efficient-Market Hypothesis, in its weak-form incarnation (which is the most empirically supported one). As any financial prospectus will (or at least, should) tell you, past returns are no guarantee of future performance. It is impossible to predict what is going to happen in the market because if it were, people would. For example, if prices were going to rise at some point in the future and this was predictable, demand would increase. But then prices would rise already! What this means is that it is impossible to systematically make economic profit (or above market profit) from any given investment strategy, except by luck. For the most part share prices are like an old man at the supermarket, they follow an unpredictable, random walk.

This obviously precludes a lot of talk about how the NZ Super Fund managers are skilled, unskilled, or whatever. Kenneth French gives a good example of how it is easy to mistake luck for skill:

Consider, for example, a hedge fund with an annual volatility of 20%. (To be more precise, the standard deviation of the fund's excess return with respect to the appropriate benchmark is 20%.) If the fund's average abnormal return is 5% per year over a ten-year period, many investors and financial reporters would conclude that the manager is truly gifted, with a real knack for identifying under- and over-valued securities. But they would probably be wrong. Suppose the manager's true alpha is zero, so he really has no skill beyond that needed to recover his costs. If we pretend his returns are normally distributed, the probability that his average abnormal return exceeds 5% per year for a ten year period is more than 20%. In other words, in a group of hedge fund managers with standard deviations of 20%, we expect one in five to have a ten-year average annual abnormal return of at least 5%—even if none actually have any skill. We expect one in twenty of the unskilled managers to produce a ten-year average annual abnormal return of at least 10%.

French and Eugene Fama (the 'inventor' of the EMH) have an interesting paper on this here.

The second argument for why we need a super fund is that somehow it can make more money simply by virtue of being large. I cannot, to be honest, see how this could be true. But even if it were, the New Zealand Super Fund is hardly a massive player on the global stage. China, for example, has a fund (used for different purposes) of over $1t. If there were advantages to be made from having more money, other people would be getting them first. Some economies of scale are non-rival, it's true. But it seems unlikely that the NZ Super fund will somehow be able to buy stocks at below-market rates just because it has lots of capital.

As I've said before, the real test of someone's conviction that there is a lot of money to be made on the financial markets is their own financial position. If beating the market is so easy, do it yourself.

To The Point

Here Eugene Fama, the man who more or less invented the Efficient-Market Hypothesis, pithily defends it against an attack from George Soros, a famous hedge fund manager.

EFF: All the evidence I know says that market predictions are unbiased. It's understandable, however, that hedge fund managers are immune to this evidence since it's a threat to their existence.

If You're So Smart...

Scott Sumner makes an excellent point:

Whenever I read opinion pieces by almost any macroeconomist— Keynesian, monetarist, new Classical, Austrian, etc, there is almost invariably a point where alarm bells go off. At some point the economist will make an assertion that seems to me to be in conflict with the EMH. And after that point I have trouble taking anything they say seriously. I keep thinking “If you’re so smart . . . ”

What Sumner implies is more likely is that the market is working from the same data as you, and it has priced in the probability of your predictions already. It's more than a little hubristic to think that you've figured out something that no-one else can understand.

Also, if you think you're aware of a weakness in financial markets, be it regulatory or just some failure of the market to price something correctly - why aren't you rich?! If you're totally confident of your model, before you tell anyone (or even after, if you don't think they'll believe you), use it to make money! Whether or not you actually do this, I think this is a good internal confidence check, and perhaps you should use the results to determine how strongly you advocate for your desired remedy.

Update: Arnold Kling responds, saying that Sumner presents a false dichotomy between believing in the EMH and being rich:

But one can believe that the markets are wrong and still not get rich. The markets can be right. Or, the markets can be wrong in ways that you did not expect. As an investor, the prudent approach may very well be to act as if markets are efficient. Load up on those stock index funds and those inflation-indexed Treasury securities, and be done with it.

Surely if you consistently bet that the markets are wrong and it turns out they're right, you should reconsider the EMH! If the market is wrong in ways you did not expect, then unless someone expected it, that isn't necessarily an argument against the EMH. It may have been that whatever information the market needed to make the correct call just wasn't there. The EMH doesn't mean that markets are omniscient, simply that they price all available information. If Barack Obama abolished lending at interest, the markets would plunge. This wouldn't be evidence against the EMH.
I also don't think that the market has to be perfectly efficient for Sumner's point to stand. If the market were arbitrarily or randomly inefficient, demonstrating this still wouldn't help you make money off it.

Here's a thought: if it became common knowledge that the market was informationally inefficient in some systematic way (animal spirits, etc), would the market price that and cancel it out? Is the only thing precluding us from a more efficient market a lack of scholarship?