Empirical Asset Pricing: Eugene Fama, Lars Peter Hansen, and Robert Shiller

In my paper, Empirical Asset Pricing: Eugene Fama, Lars Peter Hansen, and Robert Shiller, which was recently made publicly available on SSRN and which was commissioned by the Scandinavian Journal of Economics, I explain the reasons why the 2013 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel was awarded to Fama, Hansen, and Shiller for empirical analysis of asset prices.

At one level there is nothing to explain. The 2013 Nobel laureates are giants of finance and architects of the intellectual structure within which all contemporary research in asset pricing is conducted. Their fame extends far beyond financial economics. Eugene Fama is one of the world’s most cited economists in any field. Lars Peter Hansen is an immensely distinguished econometrician, so the field of econometrics naturally claims a share of his glory. Robert Shiller is a founder of behavioral economics, a creator of the Case-Shiller house price indexes, and the author of important and widely read books for a general audience.

However, the 2013 prize attracted special attention in the media, and stimulated discussion among economists, for another reason as well. The laureates have interpreted asset price movements in strikingly different ways. Robert Shiller is famous for his writings on asset price bubbles, and his public statements that stocks in the late 1990s and houses in the mid 2000s had become overvalued as the result of such bubbles. Eugene Fama is skeptical that the term “bubble” is a well-defined or useful one. More broadly, Fama believes that asset price movements can be understood using economic models with rational investors, whereas Shiller does not.

The purpose of my article is to explain the achievements of the laureates in a way that brings out the connections among them. I do this by showing, first, that all contemporary research in finance is conducted using a conceptual framework, the so-called stochastic discount factor that provides a common language for the discovery and interpretation of empirical facts. The laureates did not originate this framework, but they have shown how to make it empirically relevant.

Next, I discuss the concept of market efficiency formulated by Fama in the 1960s. Fama first stated the “joint hypothesis problem”—that market efficiency can only be tested jointly with a model of the compensation for risk that investors require. Hansen later understood this to be as much an opportunity as a problem, leading him to develop an important econometric method for estimating and testing models of risk compensation—the Generalized Method of Moments.

I review empirical research on the predictability of asset returns in the short and long run. Fama’s early work developed econometric methods, still widely used today, for testing short-run predictability of returns. Typically, these methods find very modest predictability, but both Fama and Shiller later discovered that such predictability can cumulate over time to become an important and even the dominant influence on longer-run movements in asset prices. While Fama and Shiller may disagree about the interpretation of these facts, they do not disagree about the facts themselves.

I discuss the work of the laureates on asset pricing when some or all market participants have beliefs about the future that do not conform to objective reality. Shiller helped to launch the field of behavioral economics and its most important subfield of behavioral finance when he challenged the orthodoxy of the early 1980s that economic models must always assume rational expectations by all economic agents. Later, Hansen approached this topic from the very different perspective of robust optimal control. In effect, Hansen argues that pessimistic beliefs may be a sensible form of conservatism in the face of uncertainty about the way that the economy works.

Finally, I explore the implications of the laureates’ work for the practice of finance. Contemporary methods of portfolio construction owe a great deal to the work of Fama on style portfolios, that is, portfolios of stocks or other assets sorted by characteristics such as value (measures of cheapness that compare accounting valuations to market valuations) or momentum (recent past returns). The quantitative asset management industry uses many ideas from the work of the laureates, and Shiller’s recent work emphasizes the importance of financial innovation for human welfare in modern economies.

Each of these sections refers to the work of more than one of the 2013 Nobel laureates. In this way I hope to foster an appreciation for the intellectual dialogue among the laureates and the many researchers following their lead.

The full paper is available for download here.