Step 2: Nobel Laureates

2.2

Definitions

2.2.1

How is the Nobel Prize in Economic Sciences Awarded?

The Nobel Prize is perhaps the most globally recognized honor in each of the fields in which it is presented. To find out what a challenge it is to obtain, you can go to the official web site, or keep reading! The Nobel Internet archive is also a great resource.

Each year the category committees send individual proposals to thousands of scientists, members of academies, and university professors in numerous countries, asking them to nominate Nobel Prize candidates for the coming year. Those considered competent by these committees to submit nominations are chosen in such a way that as many countries and universities as possible will be represented.

The process is very rigorous. Nominations received by each committee are then evaluated with the help of specially appointed experts. When the committees have made their selection among the nominated candidates and have presented their recommendations to the prize-awarding institutions, a vote is taken for the final choice of Laureates.

The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel is awarded at the Prize Awarding Ceremony at the Concert Hall in Stockholm, Sweden, on every December 10th, the anniversary of Alfred Nobel's death.

2.2.2

The University of Chicago, CRSP, and the Stock Market

CRSP Celebrates 50 Years

In addition to the Nobel Laureates who have studied the stock market, thousands of academics also perform substantial and significant research in this area. The University of Chicago is the leading institution of learning in stock market research. In fact, twenty-six of today’s sixty-nine Nobel Laureates in Economics attended or taught at the University. This is an impressive thirty-eight percent of all Nobel Laureates in Economic Sciences. As of 2011, The University of Chicago list for Nobel Prizes in Economic Sciences includes: Thomas J. Sargent, 2011, Roger B. Myerson, 2007, Leonid Hurwicz, 2007, Edward C. Prescott, 2004, James J. Heckman, 2000, Daniel L. McFadden, 2000, Robert A. Mundell, 1999, Myron S. Scholes, 1997, Robert E. Lucas Jr., 1995, Robert W. Fogel, 1993, Gary S. Becker, 1992, Ronald H. Coase, 1991, Merton H. Miller, 1990, Harry M. Markowitz, 1990, Trygve Haavelmo, 1989, James M. Buchanan Jr., 1986, Gerard Debreu, 1983, George J. Stigler, 1982, Lawrence R. Klein, 1980, Theodore W. Schultz, 1979, Herbert A. Simon, 1978, Milton Friedman, 1976, Tjalling C. Koopmans, 1975, Friedrich August von Hayek, 1974, Kenneth J. Arrow, 1972, and Paul A. Samuelson, 1970.

 

Rex Sinquefield

Eugene Fama

The Univac 1 System #42, delivered to the Univ. of Chicago in Nov. 1957 as used by CRSP to assemble the data.

Why is the University of Chicago so obviously prominent? In 1959, Louis Engel, vice president at the firm then known as Merrill Lynch, Pierce, Fenner & Smith made a phone call. He asked Professor James H. Lorie whether anyone knew how well most people performed in the stock market relative to other investments. Unable to answer the question, Lorie was intrigued. He proposed that Merrill Lynch fund a project with the purpose of gathering, cleaning, and completing the prices, dividends, and rates of return of all stocks listed on the NYSE. Lorie would utilize the new capabilities offered by computers in developing a database to maintain accurate securities information over time. With a complete and accurate database, researchers would no longer need to compile their own data. The project would prove invaluable to empirical research.

CRSP is an acronym for the Center for Research in Security Prices, which is located at the University of Chicago. Established in 1960 with a $300,000 grant from Merrill Lynch & Co., CRSP undertook the massive data-gathering project. From 1964 to 1986, the Center received gifts in excess of $1 million from those who yearned for the answer as much as they did. James Lorie became the center's first director, a position he held until 1975. He and Lawrence Fisher, former Associate Professor of Finance and Associate Director of CRSP, collaborated to gather the data. The two colleagues were faced with the monumental responsibility of researching the accuracy of each piece of stock information. They made use of their own formidable training and experience to fill in the blanks for missing stock prices.

At the end of four years, Lorie estimated that between two and three million pieces of information were entered onto magnetic tape. Their stock market database was completed in 1964. Lorie and Fisher analyzed total return, dividends received, and changes in capital as a result of price changes of all common stocks listed on the NYSE from December 25, 1925 to the present. On that date there were 506 companies in the database. Only 44 of those companies are still in business. Lorie and Fisher published their findings in an articled titled RATES OF RETURN ON INVESTMENTS IN COMMON STOCKS, in the Journal of Business. In the conclusions of the paper on page 9, the article proclaimed that the average compunded rate of return on common stocks listed on the NYSE over the 35 years from 1926 to 1960 was 9% for institutional investors. For the first time in history, an average rate of return could actually be measured. The front page of the New York Times financial section heralded the pair's results. If you look at the annualized return of the IFA U.S. Large Company Index from January 1963 to December 2012, it is 9.58%. And the 85 year annualized return from January 1928 to December 2012 is 9.10%, a standard deviation of 18.32% and $1 grew to $1,645. The more things change, the more they are the same. (Note that a small value tilted IFA Index Portfolio 100 had an annualized return of 10.99%, a standard deviation of 22.66%, growing $1 to $7,060 over the same period.)

However, the project really did not get to Mr. Engel’s question. Nearly four decades later, the average investor’s performance in the market was measured by Dalbar, Inc. and was found to be significantly below the market average. Over the twenty year period ending in 2012, the average equity investor only earned 47.4% of the gain of the S&P 500.

CRSP continues to accumulate data on a regular basis. With a $180,000 grant from Dimensional Fund Advisors in 1984, data dating from January 1972 from NASDAQ markets was added. "If I had to rank events, I would say this one (the original CRSP Master Fuel) is probably slightly more significant than the creation of the universe," said Rex Sinquefield, former co-chairman and current director of DFA. "The entire field of finance has been changed and developed through that database."

2.3

Problems

2.3.1

Investors Rely on Lady Luck

The most significant problem investors have is their reliance on factors other than empirical research to select their investments. Investors are mostly speculating and relying on Lady Luck rather than Nobel Laureates. They are most often chasing the recent success of a manager, stock, time, or investment style.

2.3.2

Active Investors are Unaware of Academic Studies

The great majority of investors are unaware of the tremendous amount of academic brainpower that has been applied to investing. This lack of awareness makes investors more susceptible to the lure of active management, engaging in risks they do not understand.

There is a stark contrast between a peer reviewed non-biased academic paper and an article in The Wall Street Journal, Barron’s, Forbes, Fortune, Money, an analyst report, or the numerous other sources of investment research. Virtually every private investor is unaware of the vast amount ofacademic research that points to investing in portfolios of index funds.

 

2.4

Solutions

The solution to the void of investor information is to take a quick walk down the timeline of modern finance. Beginning nearly 350 years ago, I hope this story will lead recovering active investors to a more sound investing strategy--a diversified portfolio of index funds.

2.4.1

Get to Know the Pillars of Wall Street

Modern economics is built on the pillars of academic research, some of which have led to Nobel Prizes. The following milestones demonstrate how strongly the creativity, determination, and tireless research of thousands of individuals influenced the development of the 12-Step Program to Index Funds.

1654
Blaise Pascal
Chevalier de Mere
The Early Attempts to Quantify Risk

Modern finance began with the realization that risk needed to be measured and managed. "The intelligent management of risk" can be traced to 1654 during the Renaissance Period. This was a time of great discovery. Centuries-old beliefs were constantly under question and reevaluation. This time of rebirth challenged wizards, mystics, fortune-tellers, oracles, and soothsayers, who were previously regarded as experts on predicting the future. One day in 1654, a French gambler named Chevalier de Mere and a mathematician named Blaise Pascal tried to predict the future outcome of a game of chance.

They wanted to determine how to divide up the stakes of an unfinished game, when one player was slightly ahead. With input from Pierre de Fermat, they developed the theory of probability. This theory is the basis for the concept of risk management and modern finance. Years later in 1952, Nobel Laureate Harry Markowitz embraced what a French gambler had questioned in 1654 and converted it into the theory of Portfolio Selection. His idea revolutionized the investment process! (Also see How Do We Measure Risk)

1690
Edmund Halley
Beginning to Understand Risk Management  

Edmund Halley, the famous English astronomer who discovered Halley's Comet, began work on a series of life tables in early 1690. A probability based life expectancy could be derived from these tables, which later became the blueprint for the life insurance industry. Techniques of risk management were improved over the years, leading to one of the first commercial applications by the English government. Government officials developed life expectancy tables and sold life annuities, soon followed by marine insurance products. Halley’s work ultimately led to the founding of Lloyd's of London, which originated in a tiny English coffee shop that Halley frequented. These same principles of managing risk were later applied to the stock market.

A critical element in the development of risk management was the discovery of standard deviation and the bell shaped curve by Abraham de Moivre in 1730. Francis Galton, cousin to Charles Darwin, proposed the Theory of Regression to the Mean by 1875. This theory predicts that a result will be closer to the "normal" or the expected average over time.

1776
Adam Smith
The Wealth of Nations

In his 1776 landmark book, The Wealth of Nations, Adam Smith asserted that capitalistic countries would prosper, while non-capitalistic countries would not. His argument was based upon the concept of the invisible hand, the idea that individuals who acted in their own self-interest would benefit society as a whole. By allowing supply and demand to dictate prices, a free market economy would ensure that resources are exchanged in the most efficient manner. Similarly, index fund investing is based on the idea that market prices adjust to reflect current market conditions, and that speculating on future prices is a losing endeavor.

 

1830
Judge Samuel Putman
The Prudent Man Rule

In a case of alleged improper management of a trust account, Judge Samuel Putman presided with a decision that has become known as the Prudent Man Rule, still used today to establish proper guidelines for trustees. He stated, "Do what you will, the capital is at hazard. All that can be required of a trustee to invest is that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion, and intelligence manage their own affairs, considering the probable income, as well as the probable safety of the capital to be invested." This was one of the first authoritative and clear statements that risk has to be considered along with return.

 

1900
Louis Bachelier
The Beginnings of Random Walk Theory

The year 2000 marked the centennial of the Random Walk Theory of stock market prices. One hundred years since the theory's conception, the overwhleming majority of investors are still not convinced that the markets move in a random fashion. Many scholars confirmed and refined the research of Louis Bachelier, the hapless unsung hero of financial economics. He wrote "The Theory Of Speculation" in 1900 and presented it as his doctoral thesis to the faculty of the Academy of Paris. Bachelier anticipated much of what was later to become standard fare in financial theory: the random walk of financial market prices. "There is no useful information contained in historical price movements of securities."

Samuelson on Bachelier

Samuelson on Bachelier 2 Source: The Trillion Dollar Bet

As is typical with great minds, his professors and contemporaries did not appreciate his innovation. His thesis received humiliating marks from his professors, and he quickly dropped into the shadows of the academic underground. After a series of minor posts, he ended up teaching in an obscure French town for much of the rest of his life. His valuable work was largely ignored until the mid-1960’s when now Nobel Laureate Paul Samuelson unearthed and elaborated on his findings.

MIT professor Paul Cootner published a 500-page collection of research reprints on the randomness of the market in 1964. The Random Character of Stock Market Prices contained the first full text English translation of Bachelier's 1900 thesis. Cootner delivered this accolade about Bachelier: "So outstanding is his work that we can say that the study of speculative prices has its moment of glory at its moment of its inception."

The Random Walk Theory describes the way stock prices change unpredictably as a result of unexpected information appearing in the market. This "random walk" of changing prices has created a misconception among investors that stock prices change randomly for no rational reason. It is not the changes in stock prices that are random, but the news that is random. News is inherently unpredictable, or it would not be considered news. In reacting rationally to new information, the stock prices look as though they behave in a random fashion. Many others, including Paul Samuelson and Eugene Fama, would later expand on Bachelier’s work.

See these two informative articles (pdf format) on Bachelier: 1, 2.

1906
Francis Galton
Vox Populi (Voice of the People)

The English scientist Francis Galton, founder of the science of measuring mental faculties, discovered that the wisdom of the many is more accurate than the wisdom of a few. Galton arrived at this discovery in 1906 at a livestock convention where a crowd of about 800 was asked to guess the weight of an ox. Galton added up all of the guesses and calculated the average. The crowd had collectively guessed that the ox weighed 1,197 pounds, just a pound away from the actual weight of 1,198 pounds. While no one individual came as close to the actual weight, the collective crowd’s average estimate hit it almost spot on. From this, Galton concluded that a crowd of regular individuals making independent guesses based on their own independent experiences comes the closest to matching the performance of experts.

The world’s equity markets prove out Galton’s discovery. Millions of investors throughout the world contribute their independent estimates of a stock’s value, resulting in a price that is more accurate than any one individual’s guess. This is the primary reason why indexing works; the market’s price embodies the wisdom of the crowd as it reacts to the news about capitalism.

1932
Alfred Cowles
The Standard & Poor's 500 Index

In 1932, Alfred Cowles established the Cowles Commission for Research in Economics with the motto, "Science is Measurement." He also funded the Econometric Society's journal, Econometrica. (see these great papers) The Commission moved to the University of Chicago in 1939 and later to Yale University in 1955, where it was renamed the Cowles Foundation. Almost every U.S. winner of the Nobel Prize in Economics has spent time with the Cowles Commission.

In need of a measurement stick, Cowles created a market index in 1938, which became the basis for the 1957 introduction of the Standard & Poor's 500 Index. The goal was to establish a stock market index to represent the average experience of stock market investors. After sweeping failures in forecasting the 1929 crash, the prominent Colorado businessman and investment counselor wanted to focus his considerable statistical skills on analyzing stock market forecasters' ability to choose a portfolio that beats a market average or index.

Cowles reviewed approximately 12,000 recommendations and four years of transactions by twenty leading fire insurance companies and published his results in a July 1933 article titled, Can Stock Market Forecasters Forecast? His conclusion was, "It is doubtful." His extensive study of stock market data provided an early demonstration of the "random walk" in stock price movements and the beginning of the Efficient Market Hypothesis. Cowles published a follow-up study in 1944, reviewing 6,900 market forecasts over a period of 15.5 years. Once again, he concluded there was no evidence supporting the ability of the forecaster to predict the future of the market. His studies were the first of over 200 in the area of active manager performance measurements.

Cowles determined that despite his research and the research of countless others after him, investors would continue to listen to market forecasters, because they truly wish to believe that somebody, anybody, knows what the future will bring. Most people think that a world in which nobody has a clue is genuinely frightening.

The Cowles Commission in their original Colorado Springs office (more photos.) From left; Professor Gerhard Tintner, Dickson H. Leavens, Dr. Harold T. Davis, Herbert E. Jones, Alfred Cowles (photo courtesy of the Cowles Foundation)

The motto "Theory and Measurement" was first adopted in 1952. It succinctly captures the mission of the Cowles Foundation, which is the development and application of rigorous logical, mathematical, and statistical methods of analysis in economics and related fields. This motto replaced the original Cowles Commission original motto "Science is Measurement," reflecting the importance of theory that became clear early in the history of Cowles. Over the years Cowles scholars have made important contributions to economic theory, to econometric theory, and to a broad range of fields of economics through work that combines economic models with statistical methods of measurement. The mission of "theory and measurement" is reflected in the broad range of Cowles activities today, including those of its four core research programs in Econometrics, Economic Theory, Macroeconomics, and Structural Microeconomics.> Source: Cowles Foundation>

 

1952
Harry Markowitz, (Also see The Harry Markowitz Page)>
Nobel Prize in Economic Sciences, 1990
Efficient Diversification

"Don't bet the ranch.
Get more bang for your buck.
Maximize output relative to input.
Nothing ventured, nothing gained.
Diversify instead of striving to make a killing.
Don't put all your eggs in one basket; if it drops, you're in trouble.
High volatility is like putting your head in the oven and your feet in the refrigerator."

These common sense sayings capture the essence of Harry Markowitz's brainstorm, sparked one afternoon as he sat in the University of Chicago library reading a book about the current thinking of stock market investing. At 25 years old, Markowitz thought investors should be equally concerned with the volatility or risk of investments as they are with the return of investments. Thirty-eight years later, this innovative, practical theory earned him the 1990 Nobel Prize in Economics. This landmark contribution to the investment world was first published in 1952 in an essay entitled, "Portfolio Selection." He later authored a book entitled, Portfolio Selection: Efficient Diversification of Investments (1959).

Using several stocks from the New York Stock Exchange, Harry Markowitz created the first efficient frontier. The image below and to the left is reproduced from his book, Portfolio Selection, Cowles Monograph 16, Yale University Press, 1959. It has a line going to the origin, because Markowitz was interested in the effects of combining risky assets with a riskless asset: cash.

The theory developed in Portfolio Selection was a theory for optimal investment in stocks that differ in regard to their expected return and risk. Investment managers and academic economists have long been aware of the necessity of taking both risk and return into account. Markowitz's primary contribution consisted of developing a rigorously formulated operational theory for portfolio selection under uncertainty. His theory evolved into a foundation for further research in financial economics. Markowitz was the first to place a number on risk relative to investing. Risk was previously discussed in general terms and based more on feeling or intuition. He was able to quantify the "undesirable thing" an investor tries to avoid by using a range of possible return outcomes, based on the past variability of returns.

Under certain conditions, Markowitz showed an investor's portfolio choice can be reduced to balancing two dimensions: the expected return on the portfolio, and its variance or standard deviation. The risk of a diversified portfolio depends not only on the individual variances of the return on different assets, but also on the opposite movement of all assets. When one asset class goes up, another goes down. The opposite movement results in a higher return than if all of the assets go up or down together. He said, "Diversification is both observed and sensible. A rule of behavior which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim." At twenty-five, Markowitz already knew that focusing on return without proper consideration of risk creates portfolios that are less than desirable.

Markowitz's contribution extended to making the distinction between the risk of an individual stock and the risk of a portfolio. He showed how individual risky stocks lose much of their risk if combined with less risky stocks in a portfolio. What is remarkable about Markowitz's discovery is that an investor can reduce the volatility of a portfolio and increase its return at the same time.

When Markowitz began to formulate his ideas in the 1950’s, leading investment guides recommended that an investor should find one stock with the highest expected return, invest in it, and ignore all the others. If investing involved no amount of risk, holding investments with the highest expected returns would be a highly profitable idea. The experienced investor knows that investing is full of risk. Risk essentially means that more can happen than will happen, which adds great uncertainty to investment decision-making. People do not expect to be in an auto accident, but they invest in auto insurance because of the unpredictable possibilities. People also do not expect a stock in their portfolio to decrease in price, but it can and will at some point. If an investor’s portfolio is diversified, then the loss incurred from that one stock will be “insured” by other stocks that do not decrease in price. Markowitz knew that in the real world, investors are not only interested in return, but they are concerned with risk as well.

Markowitz concluded that risk is central to the whole process of investing. He then wondered how to measure the appropriate amount of risk to undertake. Markowitz came to realize the cruel truth of investing: investors cannot earn higher returns without taking on greater risk, and the greater the risk, the greater the possibility of loss. He set out to devise ways to help investors apply tradeoffs between risk and return. Using mathematics to solve the puzzle, Markowitz discovered a remarkable new way to build an investment portfolio, which he called the "efficient portfolio.” It offers an investor the highest expected return for any given level of risk, or the lowest level of risk for any given expected return.

Read "What to do about the 2008 Financial Transparency Crisis" - Nobel Prize Winner and IFA Academic Consultant Harry Markowitz outlines a solution for resolving the current financial crisis.

Below: An Hour with Harry Markowitz - March 9, 2012

1958
James Tobin,
Nobel Prize in Economics, 1981
The Separation Theorem

Harry Markowitz was primarily concerned with the diversification of risky assets. James Tobin added the concept of combining risk-free assets, such as cash or bonds, with risky assets, such as stocks. His paper, "Liquidity Preference as Behavior Toward Risk" appeared in The Review of Economic Studies in February 1958. The concept he described is known as the Separation Theorem, because it separates Markowitz's approach from the completely different decision of dividing up the whole portfolio between risky and risk-free assets.

Tobin also performed an analysis of financial markets and their relationship to expenditure decisions, debt decisions, employment, production, and prices.