Is the Market Rational?
Nobel laureate Robert Shiller showed that fluctuations in the stock market were consistent with fads and euphoria.

Sweden’s central bank recently awarded the Nobel Prize in economics to Robert Shiller, of Yale University, and Eugene Fama and Lars Hansen, of the University of Chicago, for their research into the sources of price fluctuations in the stock market. I have known Bob Shiller for 47 years, first as a fellow PhD student at MIT, then as a colleague, coauthor and best friend. His Nobel Prize was an honor richly deserved.
Shiller’s work supported the belief that the financial markets are frequently irrational. So, many people thought it odd, if not downright confusing, that the prize was also awarded to Fama for his work in support of the efficient-market hypothesis, which states that prices always rationally reflect all the information that’s available about securities. On closer examination, the conclusions of Shiller and Fama aren’t as contradictory as they first appear.
Shiller’s most important contribution was his 1981 article titled “Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends?” His answer was a resounding yes. He showed that fluctuations in the stock market were consistent with fads and euphoria that had little to do with the fundamental factors that determine the price of an asset. Shiller’s work gave a boost to the behavioral finance wing of the finance profession, which challenged the theory of rational investors and efficient markets that most academics embraced.
From just $107.88 $24.99 for Kiplinger Personal Finance
Be a smarter, better informed investor.

Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Gene Fama, however, had been a strong supporter of the efficient-market hypothesis. And if its contention that securities prices reflect all publicly available information was correct, investing on the basis of widely known fundamental factors could not improve investor returns.
Yet Fama, along with Dartmouth professor Kenneth French, showed that contrary to the efficient-market hypothesis, there appeared to be publicly known factors—such as a company’s size, earnings, cash flow and book value—that could be used to predict stock returns. In a 1996 article, they concluded that their results could be “consistent with specific irrational-asset-pricing stories.”
What Fama and French found is what value investors such as Warren Buffett and Benjamin Graham have long known. If market prices do not always reflect fundamentals, then investors can indeed achieve superior returns by buying stocks when they are cheap and out of favor—when, say, their prices are low relative to a company’s earnings, dividends or book value. In fact, Fama is a director and consultant for Dimensional Fund Advisors, a successful firm that manages more than $300 billion in portfolios that pick stocks according to specific criteria that historically have produced superior results.
Reacting to uncertainty. Although Fama seemed to open the door to irrational-asset-pricing stories, his own belief is that it is wrong to call these anomalies irrational. He says that we have yet to discover a more general theory to explain what we observe, just as the irregularities in celestial orbits first observed in the Middle Ages were eventually explained by the sun-centered view of the solar system.
The research of Fama and Shiller has challenged the profession to determine whether fluctuations in asset prices are better explained by psychological and behavioral factors or by a more general theory of how investors react to uncertainty. The Nobel committee concluded that both men have made progress toward this end. The committee also awarded the prize to Lars Hansen, who developed innovative empirical techniques to test whether the market is efficient. I was honored to have been invited to Stockholm to celebrate their awards.
Profit and prosper with the best of Kiplinger's advice on investing, taxes, retirement, personal finance and much more. Delivered daily. Enter your email in the box and click Sign Me Up.

-
Amazon Ends Free Shipping Benefit Sharing with Non-Household Members
Starting October 1, Prime members will no longer be able to share shipping perks with those outside their household.
-
Big Tech Names Rise Above Broad Weakness: Stock Market Today
Some familiar names enjoyed solid rallies on the resolution of outstanding questions, but macro uncertainty hangs over the broader market.
-
9 Warren Buffett Quotes for Investors to Live By
Warren Buffett transformed Berkshire Hathaway from a struggling textile firm to a sprawling conglomerate and investment vehicle. Here's how he did it.
-
A Timeline of Warren Buffett's Life and Berkshire Hathaway
Buffett was the face of Berkshire Hathaway for 60 years. Here's a timeline of how he built the sprawling holding company and its outperforming equity portfolio.
-
Berkshire Buys the Dip on UnitedHealth Group Stock. Should You?
Buffett & Co. picked up UnitedHealth stock on the cheap, with the embattled blue chip one of the newest holdings in the Berkshire Hathaway equity portfolio.
-
What Set Warren Buffett Apart
As Warren Buffett prepares for retirement, we reflect on what we've learned from his 60 years of leadership at Berkshire Hathaway.
-
Value vs Growth Investing Isn't So Simple
The difference between growth and value stocks isn't black and white.
-
If You'd Put $1,000 Into Berkshire Hathaway Stock 20 Years Ago, Here's What You'd Have Today
Berkshire Hathaway is a long-time market beater, but the easy money in BRK.B has already been made.
-
I'm an Investing Expert: This Is How You Can Invest Like Warren Buffett
Buffett just invested $15 billion in oil and gas, and you can leverage the same strategy in your IRA to potentially generate 8% to 12% quarterly cash flow while taking advantage of tax benefits that are unavailable in any other investment class.
-
7 Essential Investing Rules We All Should Know
The best time to start investing is right now. That's just one vital rule investors should be familiar with. Here are six more.