For as long as there has been a stock market, investors have sought a reliable framework to determine the future direction of prices. Success has been elusive. But thanks to the work of three American economists, we operate today with a better understanding of what determines an asset’s price than the generations of investors that came before us.
For their work, Eugene Fama, Lars Peter Hansen, and Robert Shiller were awarded the 2013 Nobel Memorial Prize in Economics. We can see the impact of their research in the development of low-cost index mutual funds and a methodology for identifying when home prices may reach irrational levels.¹
Fama is considered the father of the “efficient markets theory,” which postulates that markets are exceedingly good at incorporating all known information into the value of an asset, making it difficult to predict the short-term direction of a stock or bond.²
Fama is famous for describing market movements as nothing more than a “random walk,” discounting the efficacy of price-prediction models. This view led to the conclusion that investors could do as well, or even better, by investing in a passively managed index fund.
- Keep in mind that the return and principal value of stock prices will fluctuate as market conditions change. And shares, when sold, may be worth more or less than their original cost.
- The market value of a bond will fluctuate with changes in interest rates. As rates rise, the value of existing bonds typically falls. If an investor sells a bond before maturity, it may be worth more or less that the initial purchase price. By holding a bond to maturity an investor will receive the interest payments due plus his or her original principal, barring default by the issuer. Investments seeking to achieve higher yields also involve a higher degree of risk.
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