Stockholm 2013

An unexpected pair of Nobel Prizes helps us better understand investment markets.

In 2013, an unusual event occurred in Stockholm. When that year’s Nobel Prizes in economics were awarded, two of the winners presented a seeming contradiction. One was Eugene Fama, who developed key ideas in finance that are known as Modern Portfolio Theory (MPT). According to this theory, stock prices are always rational because they reflect all available information. Thus, according to MPT, there can be no such thing as a bubble, because—by definition—prices are always accurate. When share prices are high, in other words, it’s for a good reason and not because investors are irrational.

Another of the Nobel winners that year, however, was Robert Shiller, whose work argued precisely the opposite. In Irrational Exuberance, he demonstrated that markets aren’t always rational and that asset bubbles can and do occur—with the run-up in the late 1990s being a prime example.

Despite these opposing views, the Nobel committee granted both Fama and Shiller the prize in economics at the same time. How did the committee explain its decision? On the one hand, it agreed with Fama: “Stock prices are extremely difficult to predict in the short run.”

But over the long term, the committee said, prices are more predictable, and valuation metrics like the CAPE—while not perfect—can be helpful.

In other words, Shiller and Fama can both be right, even if their ideas seem at odds. Both have acknowledged this, if grudgingly. In an interview, Fama explained it this way: Modern Portfolio Theory “is a model, so it’s not completely true. No models are completely true.” But, he added, “It’s a good working model for most practical uses.” And that’s the key point: Markets may be rational over the long term but are often irrational in the short term. This idea can help investors maintain equanimity through the market’s regular ups and downs

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