Investing Isn’t Rocket Science
– No, It’s Harder than That!

On December 10, 1896, Alfred Nobel died. He left a lot of money for scientific prizes named after him. In honor of his death date, the Nobel Prize ceremony is usually held on this day, December 10. The first ceremony was in 1901 when the first Nobel Peace Prize was awarded to the Swiss founder of the Red Cross, Jean Henri Durant. The 1901 Physics prize went to Wilhelm Roentgen for the “remarkable rays” named after him. The 1903 Physics prize went to Pierre Curie and Marie Curie – the first female winner.

Three “hard” sciences have been awarded Nobel Prizes since 1901, namely physics, chemistry and physiology or medicine. The softer, more subjective awards are for Literature and Peace. Since 1968, the Nobel commission has added the “Nobel Memorial Prize in Economic Sciences,” but the question facing us today is whether economics is more of a hard science, like Physics, or a creative art, like Literature.

Since the days of John Maynard Keynes, economists have tried to turn their profession into a science, using calculus to create complex mathematical models, which they call “econometrics.” Alas, in the end, as Alan Greenspan unburdened himself in his recent tome, “The Map and the Territory,” economics is more about our “animal spirits” – greed, fear and mob behavior – than bloodless mathematical models.

That brings us to the three winners of the 2013 Nobel Prize for Economics. Each won the big prize for his work in how to apply mathematical models to asset values – like stock prices. The problem is that all three came to strikingly different conclusions. In Physics, this would be like Albert Einstein and Neils Bohr (the 1921 and 1922 winners) having divergent opinions about how gravity works, or the speed of light.

Meet the 2013 Nobel Prize Winners – Eugene Fama, Robert Shiller and Lars Hansen

Here are the Nobel Prize winners and their divergent views.

Eugene Francis Fama, age 74, is Professor of Finance at the University of Chicago. He is often called the father of the “efficient market” hypothesis which stemmed from his doctoral thesis. He is best known for using exhaustive market databases to formulate theoretical and empirical (real life) portfolio decisions.

Robert James Shiller, 67, often appears on CNBC in connection with his famous housing index, as well as his market predictions. He is currently Professor of Economics at Yale, after holding key positions in the National Bureau of Economic Research and the American Economic Association. He is also co-founder and chief economist for an investment management firm, MacroMarkets LLC. Unlike Fama, Shiller is noted for pointing out market inefficiencies and price anomalies within the major markets.

Lars Peter Hansen, 61, is perhaps lesser known to investors than the other two. Like Fama, he teaches at the University of Chicago as the David Rockefeller Distinguished Service Professor of Economics. He is best known for his studies on the interface between the financial and the “real” sectors of the economy.

All three plow the same field – asset valuation – but they emerge with different answers. Fama says that most markets are “informationally efficient,” since most investors revalue prices almost instantaneously to reflect any new information. In shorthand, the news is rapidly reflected, or baked into, the market price.

Shiller doesn’t think investors are that smart or rational. Investors are subject to animal spirits, prisoners of their human nature and subject to mob psychology. Shiller proved in the 1980s that stock prices move in much wider swings than their underlying dividends, which are far more predictable than stock prices.

A famous case in point is Shiller’s book, “Irrational Exuberance,” which was first published in March of 2000, the exact month of the peak in NASDAQ and S&P 500. In his 2005 update to that book, Shiller added a section on how overvalued the U.S. housing market had become. He showed that housing was a case of greed fueled by unrealistic previous price increases. His predictions were once again right on the money, as real estate prices soon peaked and began to fall precipitously over the next few years, as reflected in the housing index that Shiller pioneered – now called the S&P Case-Shiller home price index.

The tie-breaker in this argument comes from Lars Hansen, who studies the causes of market volatility. He seems to lean more toward Shiller’s view, that the wide variations in asset prices within a short time cannot be caused by slight changes in valuation measures. Such swings are not explainable by normal valuation models, so Hansen focuses on those “moments” of change, when investors vacillate from manic to depressive. This seems to be the origin of the recent fixation with the terms “risk on” and “risk off.”

While Shiller and Hansen seem to dispute Fama’s conclusions, Fama has won the allegiance of armies of index fund managers, who deny the value of individual stock selection in favor of exchange-traded funds (ETFs) and various index funds, which try to reflect the movement of indexes by constantly rejiggering the funds’ contents to reflect the market capitalization of each stock in the index, thereby exacerbating the size of the market’s swings, as index fund managers are forced to chase the “hottest” stocks in the index.

Successful Investing Differs from Econometric Modelling

My father was a rocket scientist, of sorts. During my college years (1963-67), he was a Boeing engineer and project manager in Huntsville, Alabama, and New Orleans, helping build the Saturn booster rockets. In retirement, dad applied his scientific skills to the stock market. He kept elaborate graphs of each stock he followed – by price, dividend, P/E and other ratios. It was all very mathematical, but his track record was unsatisfactory, so he asked for my advice. Looking at all his charts, I said, “Dad, investing isn’t like rocket science. It’s harder than that.” He wasn’t sure if had lost my marbles, so I explained: “Investing involves real people making emotional decisions, usually bad decisions. In rocket science, you can project a missile into space with known variables, with almost exact precision. With investing, you have to work with human beings. The numbers have some limited value, but they won’t be able to predict stock prices.”

Justin Fox’s 2009 book, “The Myth of the Rational Market” covered how physicists from the Los Alamos National Laboratory launched the Santa Fe Institute, which attempted to apply chaos theory to markets. Fox wrote: “Physicists struggled with the reality that sentient beings are harder to work with than, say, subatomic particles.” One physicist, J. Doyne Farmer, said economics is “a harder field than physics.”

In my 30+ years of working with financial newsletter editors, I’ve run into many former engineers who became investment advisors, lured by the fascination of seeking scientific formulas for profits. These advisors became successful, but only by accounting for investor sentiment and other emotional elements.

Prices will always swing in wide arcs – due to human excesses, not just logic. That fact will always give investors a chance to beat the markets. After all, it’s almost un-American to strive to be just “average.”

- Gary Alexander
Navellier Market Mail

Posted by on December 10th, 2013 at 5:23 pm

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.