March 1, 2014

The Fama-Schiller Nobel Prize Paradox: Why You Should Understand It

““....last year’s Nobel prize for economics was awarded to two scholars who had advanced investment theories directly opposed to each other...”.



Reconciling Opposing Views of Market Efficiency

Woody Brock’s monthly profile pieces never disappoint. In his March 2014 edition he provocatively asks how Profs. Fama and Schiller could both be awarded the 2013 Nobel prize in economics for what appear to be opposing theories of market efficiency. His reconciliation of their apparently opposing conclusions is both intriguing, and important for people in the pension investment world to understand. This Letter briefly recounts his explanation, and then goes on to expand on it, and to relate the conclusions to the challenges of asset management in general, and of pension fund management in particular.   

Briefly stated, Fama presents logic and evidence in favor of market efficiency, implying it is impossible to beat the market. Schiller presents logic and evidence in favor of market inefficiency, implying it is possible to beat the market. Can they both be right? Brock answers “yes they can”. It is all a matter of definitions and assumptions about:

  1. How economic processes vary over time: they can be stationary (i.e., we know the means of factors such as GDP growth and inflation, and how actual experience varies around them), non-stationary (i.e., we don’t know the means and how they vary), or they can be somewhere in between the two (i.e., exhibit “sloppy mean reversion” dynamics).

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