Fama, Hansen & Shiller (2013): Can You Beat the Market? It Depends on Your Time Horizon

The Paradox at the Heart of Finance

There is no way to predict the price of stocks and bonds over the next few days or weeks. But it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years.

This paradox — short-term unpredictability combined with long-term predictability — is the central finding of the 2013 Nobel Prize. Three economists, approaching asset prices from very different angles and reaching seemingly contradictory conclusions, together painted the most complete picture we have of how financial markets work.

Eugene Fama showed that markets are remarkably efficient in the short run. Robert Shiller showed that markets can be wildly irrational in the long run. Lars Peter Hansen built the econometric tools to rigorously test both claims.

Fama: The Efficient Market Hypothesis

In the early 1960s, Eugene Fama examined stock price data and found a striking pattern: price changes are essentially unpredictable. Tomorrow’s stock price is as likely to go up as down, regardless of what happened today or yesterday.

This led to the efficient market hypothesis (EMH): asset prices reflect all available information. If a stock is underpriced, someone will buy it, pushing the price up. If it’s overpriced, someone will sell, pushing it down. This happens so fast that by the time you hear about an opportunity, it’s already gone.

Fama distinguished three forms of efficiency:

• Weak form: Prices reflect all past trading information. You can’t profit from studying price charts (technical analysis doesn’t work)
• Semi-strong form: Prices reflect all publicly available information. You can’t profit from reading financial statements or news (fundamental analysis doesn’t work either)
• Strong form: Prices reflect all information, including insider knowledge. Even insiders can’t consistently profit

The evidence Fama assembled was powerful:

• Stock prices follow a random walk — past returns don’t predict future returns
• Mutual fund managers, on average, don’t beat the market after fees. The few who do are statistically indistinguishable from luck
• Prices adjust to new information (earnings announcements, mergers) within minutes, leaving no exploitable window

The practical implication was revolutionary: most investors should buy index funds rather than trying to pick stocks. This insight spawned the multi-trillion-dollar index fund industry.

Shiller: Irrational Exuberance and Long-Run Predictability

Robert Shiller looked at the same markets and saw something very different. While Fama focused on short-term price changes, Shiller examined long-term price levels — and found them far too volatile to be explained by rational responses to information.

Excess volatility: In 1981, Shiller showed that stock prices fluctuate far more than the underlying dividends they’re supposed to reflect. If prices equal the discounted value of future dividends, and dividends are relatively smooth, why do prices swing so wildly? Something beyond rational information processing must be at work.

Long-run predictability: Shiller discovered that the price-to-earnings ratio (specifically his cyclically adjusted P/E ratio, or CAPE) predicts stock returns over the next 3-10 years. When stocks are expensive relative to earnings, future returns tend to be low. When they’re cheap, future returns tend to be high. This directly contradicts the efficient market hypothesis — if markets are efficient, no publicly available ratio should predict returns.

Behavioral explanations: Shiller argued that psychology drives much of market behavior:

• Irrational exuberance: Shiller coined this phrase (later used by Fed Chairman Greenspan) to describe the speculative bubbles that periodically grip markets. He warned about the dot-com bubble in 2000 and the housing bubble in 2005 — both before they burst
• Feedback loops: Rising prices create optimism, which attracts more buyers, which pushes prices higher — a self-reinforcing cycle disconnected from fundamentals
• Narrative economics: Stories and media coverage shape investor sentiment, driving prices away from rational values

Hansen: The Tools to Test Both

Lars Peter Hansen developed the Generalized Method of Moments (GMM) — a statistical framework flexible enough to test asset pricing models without requiring all the restrictive assumptions of traditional methods.

Why GMM matters:

• Testing efficiency: Asset pricing theories make predictions about the relationship between risk and return. Hansen’s GMM provides a rigorous way to test whether observed prices are consistent with these theories — or whether they reveal anomalies
• The Hansen-Jagannathan bound: Hansen (with Ravi Jagannathan) derived bounds on how volatile the “stochastic discount factor” must be to explain observed asset returns. When actual returns violate these bounds, something is wrong with the model — pointing to either market inefficiency or missing risk factors
• The equity premium puzzle: Hansen’s methods helped quantify one of finance’s deepest puzzles — stocks have historically returned far more than bonds, more than any standard model of risk aversion can explain. This “equity premium puzzle” remains unsolved and suggests our models of risk are incomplete

The Productive Disagreement

The beauty of the 2013 prize was honoring three scholars who fundamentally disagree:

• Fama says markets are efficient — prices reflect information, and apparent anomalies are compensation for risk
• Shiller says markets are driven by psychology — bubbles and crashes reflect human irrationality, not rational risk assessment
• Hansen says we need better tools and models — the disagreement between Fama and Shiller may reflect our incomplete understanding of risk rather than a simple right-or-wrong answer

The resolution may be that both are right at different time horizons: markets are impressively efficient at processing information day-to-day, but human psychology creates slow-moving waves of optimism and pessimism that make long-run returns predictable.

Their 2013 Nobel Prize was awarded “for their empirical analysis of asset prices.”

Explain It to a Child

Imagine a jar of jellybeans at a school fair. Everyone guesses how many are inside. Fama discovered that if you average all the guesses, the crowd gets amazingly close to the right answer — that’s like the stock market being “efficient.” No single person can consistently guess better than the crowd. But Shiller noticed something else: sometimes everyone gets excited and guesses way too high, and sometimes everyone gets scared and guesses way too low. Over a few years, these mood swings are predictable — after everyone guesses too high, the next round of guesses tends to come back down. And Hansen? He built the ruler to measure exactly how far off the guesses are, so we can tell whether the crowd is being smart or silly.