The Nobel Memorial Prize in Economic Sciences (officially the Swedish National Bank’s Prize in Economic Sciences in Memory of Alfred Nobel) was awarded last week, as it has been every October since its inception in 1969. Generally regarded as the most prestigious award in the field of economics, it has also been the kindling for a continuous debate as to whether finance is accurately characterised as a science. Some critics argue that the award’s remit should be widened to political science, psychology, and sociology, while others, such as the authors of The Nobel Factor: The Prize in Economics, Social Democracy, and the Market Turn, postulate even further, describing finance as more like art and the Nobel prize propaganda for the free-market economy.
The award makes a fascinating story, however the profound impact Nobel laureates have achieved in their scientific approach to economic questions, formulating and testing theories, is more significant. Sceptics go too far in their accusation that economics is not a useful basis for informed speculation. Like many sciences, economics has a strong foundation in mathematics and financial hypotheses are developed by testing and comparing historical data.
There is little denying that the industry does include non-scientific elements, for example, as I discussed in my recent post about behavioural finance, human emotions and investors’ decisions can play a significant role in the markets. However, this doesn’t contradict that economics at its core, tries to uncover basic universal facts. And, while economics presents its own methodological problems, the basic challenges facing researchers are not fundamentally different from those met by researchers in other fields.
I was in Austin, Texas a few weeks ago, attending a conference at the Dimensional headquarters. It was a privilege to meet Eugene Fama, Ken French and Robert C. Merton, all Nobel winners. In his talk, Fama explained “return distributions on short and long term horizons”, which broadly reviewed historical data demonstrating that the longer equities are held the better the probability of above mean returns. French presented on forming portfolios, which was reassuring as our AstutePortfolios follow this structuring process. The session with Merton on innovation in finance was inspiring, as was meeting with other leading wealth managers from around the world, who share Quadrant’s investing principles and client-focused goals.
Should the Nobel Prize in Economics matter to investors?
The short answer is “yes”. Finance, as a field of study and an area of business, shapes how the industry, wealth advisers and investors approach investing. Many of the greatest advancements in finance have come from academic research.
Modern financial theories, such as ‘Black-Scholes options pricing model’, which won Merton and Scholes the 1997 Nobel Memorial Prize, and the efficient market hypothesis (EMH), for which Fama shared the 2013 prize with Lars Peter Hansen and Robert J. Shiller, have pioneered research on stock price patterns. EMH asserts that prices reflect values and information accurately and that it is difficult, if not impossible, to capture returns in excess of the market without taking greater-than-market levels of risk. This strong belief in markets paved the way for further evidence-based methodologies and notably the development of index funds which provide broad market exposure, low operating expenses and low portfolio turnover. The pursuit of economics as a science has benefited investors by transforming finance into a field unencumbered by emotion and grounded in fact.
While there remain many questions, like what causes market bubbles, why we experience recessions and the determinates of growth, economics is no different from other scientific fields of study such as physics or medicine. Hypotheses are constantly being challenged and are incrementally evolving. That doesn’t however; mean that we shouldn’t make decisions based on the best available evidence.
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