Lessons from the Nobel prize winning economists

Investors can learn from the differences of opinion between Eugene Fama and Robert Shiller, the winners of this year's Nobel Prize in economics.

The news that Eugene Fama and Robert Shiller were to share this year's Nobel Prize in economics left many wondering if the Royal Swedish Academy of Sciences "had a sick sense of humour", says John Authers in the FT.

The two are famously on opposite sides of a key question. Shiller's work has centred on irrational ups and downs in asset prices. But as far as Fama is concerned, markets are efficient, and thus priced correctly, so there can be no such thing as a bubble.

Yet investors can benefit from them both, says The Economist. It's a question of time frames. Fama's main insight is that stock prices factor in all available information immediately, so prices are extremely hard to predict in the short term days or weeks.

So, professional fund mangers are unlikely to beat the market, making paying up for active' funds an expensive waste of time. Investors are better off with a tracker fund, whose fees will be lower.

Shiller's work, by contrast, shows that over periods of several years stock prices are predictable, as valuations tend to revert to the mean. He devised the cyclically-adjusted price/earnings ratio (Cape), which uses a rolling ten-year average of earnings, and saw that when stocks are highly valued by this measure they would eventually fall hence his warnings about irrational exuberance in the 1990s.

The 1990s also showed that Cape, while a good indicator that a market will fall, does not predict when the fall will come.

The upshot, says The Economist, is that investors should have more of their portfolios in low-cost trackers, and be wary of equity markets where Cape is above the long-term average.

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