Understanding the Economics Nobel Prize 2013 Lasse Heje Pedersen

Economics Nobel 2013 The Sveriges Riksbank 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 2

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

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

Market Efficiency: Random Walk? Lasse H. Pedersen 5

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 6

Prices Vary Too Much for Random Walk and Mean-Revert Lasse H. Pedersen 7

If Not Random Walk, then What? the risk premium is naturally high in recessions, plus its measured with error No, it’s because people make mistakes and suffer behavioral biases My GMM method can test this stuff. I reject standard consumption-based asset pricing models, but …

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 Lasse H. Pedersen 9 the model of the risk premium is wrong and the market is efficient market efficiency is wrong I can reject any model - but is it wrong in important or unimportant ways?

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

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

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

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 13