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Nobel for decoding asset price behaviour

SUDIPTA SARANGI

This year’s Nobel Prize for Economics has gone to three stalwarts, who have worked in the area of finance and enhanced our understanding of asset prices. Eugene F. Fama and Lars Peter Hansen, both professors at the University of Chicago, and Robert J. Shiller of Yale University have been pioneers in studying the behaviour of asset prices using large amounts of detailed financial data.

While nobody can perfectly predict stock price movements, the three economists, through their own independent research, have been instrumental in providing those crucial nuggets of information that have changed the way both academics and practitioners view financial markets.Their research tells that while we cannot say much about how stock prices will behave in the immediate future, we can actually say something about their behaviour in the long run by understanding the role of risk in this process.

Asset prices are important, as their movements affect aggregate consumption patterns and investment behaviour of firms. Also, based on their current and anticipated prices, we make decisions about how much to save and in what form — cash, gold, bank deposits, stocks or real estate. Episodes of speculative behaviour when assets are mispriced are a cause of worry. This is especially so in today’s interconnected global financial markets, since they eventually lead to crashes that can in turn trigger recessions. Hence, the study of asset prices is a very important and active field in economics.

STOCK PREDICTABILITY

Fama’s research shows us that past prices cannot be used to infer anything about asset returns in the short run. What he also found was that the stock markets react to new information extremely fast and incorporate them into the price of assets. As a result, arbitrage opportunities vanish very quickly. Also, stock prices are hard to predict after the initial reaction to any new piece of information.

Although it seems counter-intuitive, there is more predictability in stock prices when we consider a longer term. Safer assets will behave differently from riskier assets and this fact can be utilised to have better predictability in the long run. Shiller demonstrated precisely this in the early 1980s. Typically, we expect stock prices to reflect the present value of all future dividend streams. However, Shiller found that stock prices move much more than dividend streams.

Consequently, if the price of any stock is high relative to dividends this year, it influences investors’ perception of it. The stock price will, then, fall relative to the dividend value in the coming years. In other words, stock returns follow a predictable pattern!

This pattern was found to be true for bonds and other assets as well.

Lars Hansen developed a statistical method called the Generalised Method of Moments (GMM) to test the Consumption Capital Asset Pricing Model (CCAPM). In any exercise requiring us to compute the present value of future cash flows, we use what is called a discount factor — how much a future rupee is worth today. Shiller had originally assumed that the discount rate is constant. But it is not clear why this should be so. Also, if the discount rate can vary, we need to explain why this may happen. The CCAPM is the most basic theoretical model connecting asset prices to savings and risky behaviour, which can systematically incorporate the role of different types of discount factors.

RATIONAL INVESTORS

Applying the GMM technique to historical stock data, Hansen demonstrated that the standard version of the CCAPM model is not valid. He, thus, showed that asset prices fluctuate too much relative to dividends even if we allow for discount factors to vary over time. All these, though, assume a rational investor, which may not be the best way to think about ourselves on any given day.

So another approach to explain long-run asset behaviour is to abandon the model of a fully rational investor and rely on “behavioural finance.”Animal Spirits, a book that Shiller co-authored with another Nobel Prize winner George Akerlof, is a nice introduction to this topic. A direct consequence of the research of the three economists is the emergence of the ‘indexed fund’ — a fund that mimics a benchmark market index like the Sensex or the Dow.

Since stock markets cannot be predicted in the short-run, and it is hard to pick stocks both in the long and short run, the best bet for a small investor probably is to put money in an indexed fund!

(The author is Gulf Coast Coca-Cola Distinguished Professor of Business Administration at Louisiana State University.)

(This article was published on October 14, 2013)

http://www.thehindubusinessline.com/opinion/nobel-for-decoding-asset-price-behaviour/article5234149.ece?homepage=true