Fama's Nobel and the Non-Science of Investing
By Staff News & Analysis - October 16, 2013

U.S. scholars Eugene F. Fama, Lars Peter Hansen and Robert J. Shiller on Monday won the Nobel Prize in Economics, the Royal Swedish Academy of Sciences announced. The three experts were honored "for their empirical analysis of asset prices." – GlobalPost

Dominant Social Theme: Economics is a hard science and don't you forget it.

Free-Market Analysis: The Nobel Prize was NOT awarded to Eugene Fama and his colleagues this week, though the same loosely affiliated cabal that tries to make central banking into a technocratic discipline wants you to think it was.

And today, we take advantage of this. The awarding of this non-Nobel provides a good opportunity to discuss why economics is not a science and why investing is not really, either.

In doing so, we can tease out the reason why the power elite has spent so much time and money trying to establish that the discipline of these "soft" sciences is on a par with, say, chemistry or physics.

Let us begin by reaffirming our point above, that not only is economics not a science, but the prize given out for insightful economic research is not a "Nobel."

As Daily Bell feedbackers have long pointed out to us, it was not established by Alfred Nobel. The Nobel Memorial Prize in Economic Sciences is known formally as the "Riksbank Prize in Economic Sciences in Memory of Alfred Nobel." Here´s the real explanation, according to Wikipedia:

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, commonly referred to as the Nobel Prize in Economics, is an award for outstanding contributions to the field of economics, generally regarded as the most prestigious award for that field.

The Prize in Economics, as it is referred to by the Nobel Foundation, was established and endowed by Sweden's central bank Sveriges Riksbank, in 1968 on the occasion of the bank's 300th anniversary, in memory of Alfred Nobel.

So a central bank established the prize! You see? Those shadowy interest groups standing behind central banks are desperate for anything that further establishes the technocratic bone fides of the banking class. It's a losing battle, but it's one that was surely joined long ago.

In fact, economics is much more an observational art than a "science." Economics as it should be practiced is certainly in part the discipline of teasing out how natural law affects human relationships. Here's part of an analysis from the Library of Economics and Liberty entitled, "Is Economics a Science?" …


Everyone recognizes that physics is a science. Everyone also recognizes economics – a "social science" – is somehow not quite the same as physics in its ability to be science-like. But what is a science and how is economics different? At first glance, a science is a way of thinking that emphasizes putting forward basic hypotheses and then doing controlled experiments that are set up to distinguish in stark relief whether each hypothesis is right or wrong. Clearly economists cannot usually do controlled experiments in a laboratory. Economists often are stuck with using historical or cross-country evidence to tease out what might merely suggest a result. Political viewpoints and the everyday language used in economics make unbiased statements or interpretations of results, or the understanding of ideas, imprecise and easily misinterpreted. Economics is a science in some ways but not others …

Definitions and Basics

Lionel Robbins, biography, from the Concise Encyclopedia of Economics

Robbins' most famous book was An Essay on the Nature and Significance of Economic Science, one of the best-written prose pieces in economics. That book contains three main thoughts. First is Robbins' famous all-encompassing definition of economics that is still used to define the subject today: "Economics is the science which studies human behavior as a relationship between given ends and scarce means which have alternative uses."…

Rosenberg on the Nature of Economics, EconTalk podcast. September 26, 2011.

Alex Rosenberg of Duke University talks with EconTalk host Russ Roberts about the scientific nature of economics. Rosenberg, a philosopher of science talks about whether economics is a science. He surveys the changes in economics over the last 25 years – the rise of experimental economics and behavioral economics – and argues that economics has become more scientific and that economists have become more aware of flaws in economic theory. But he also argues that economics is unable to make precise predictions about the effects of various changes in policy and behavior. The conversation closes with a discussion of the role the philosophy of science can play in the evolution of economics….

Diane Coyle on the Soulful Science, EconTalk podcast.

Diane Coyle talks with host Russ Roberts about the ideas in her new book, The Soulful Science: What Economists Really Do and Why it Matters. The discussions starts with the issue of growth – measurement issues and what economists have learned and have yet to learn about why some nations grow faster than others and some don't grow at all. Subsequent topics include happiness research, the politics and economics of inequality, the role of math in economics, and policy areas where economics has made the greatest contribution….

We can see from the above that even a sampling of literature reveals much doubt about economics' place as a science, certainly a hard science.


The British actually have done the most to haul economics into the scientific arena via something called "econometrics." This is the discipline of developing and using higher mathematics in a predictive way. John Maynard Keynes adopted the econometric approach; Franklin Delano Roosevelt said after one visit by Keynes that the great economist's equations made his head hurt.

When one investigates the triumphs of econometrics, it turns out that the discipline is seemingly flawed by its inability to make accurate forecasts. The models created with painstaking elegance never seem to work.

Those who follow free-market economics are not surprised by this. Free-market economics points out quite reasonably that people are not, in one memorable phrase, "potted plants." If the government is predicting starvation at some point in the future, chances are that particular forecast may not be realized because people faced with scarcity will either move or grow more food.

This goes for predictions generally and is a reason why econometrics, despite its dizzying complexity, yields up the same results as other kinds of economic analysis, which is to say inaccurate ones. Which brings us back to the "Nobel" just awarded to Fama, et al. Here's more about it, from Bloomberg:

"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," the academy said. "These findings, which might seem both surprising and contradictory, were made and analyzed by this year's laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller," the announcement said.

… "The laureates have laid the foundation for the current understanding of asset prices. It relies in part on fluctuations in risk and risk attitudes, and in part on behavioral biases and market frictions," the academy said … The work that earned Eugene Fama the Nobel Prize in economics provided the intellectual foundation for index-tracking funds, which have upended stock picking as investors abandon active money managers.

Fama, 74, has argued that financial markets are efficient and that stock-price movements are unpredictable, making it impossible for even professional money managers to gain an advantage.

His conclusion that investors would be better off in low-cost funds that track the market's performance helps explain the success of Vanguard Group Inc., the biggest U.S. mutual-fund company, as well as the rise of passive investments, which had more than $2.6 trillion in U.S. assets between exchange-traded funds and mutual funds at the end of 2012.

"His work has been seminal," F. William McNabb III, Vanguard's chief executive officer, said yesterday in an interview with Tom Keene and Sara Eisen on Bloomberg Radio's "Bloomberg Surveillance." "A lot of what we have done is based on that work."

Funds that mimic the performance of markets gained momentum after 2008 when the Standard & Poor's 500 Index fell 37 percent and investors lost faith in the ability of stock pickers to insulate them from losses.

Over the past five years, index funds have been the most popular choice for investors, with assets in U.S. ETFs almost tripling in that period. Investors have pulled about $284 billion from actively managed equity mutual funds, while pouring $243 billion into stock index mutual funds since the end of 2008, data from Morningstar Inc. show.

"Index funds have gone from a whacky fringe idea to the point where they are now viewed as the default investment option for many people," Russel Kinnel, director of mutual fund research at Chicago-based Morningstar said in a telephone interview. Some of the most highly regarded active equity managers stumbled in the past decade, a period that included the biggest stock-market slump since the Great Depression.

Fama is surely a favorite son of the banking class for observations that seem to bring economics – and investing – into the realm of hard science. But not so fast. To be truly enamored of Fama's theories, one has to ignore two things.

First, precious metals seem to have escaped Fama's consideration when it comes to asset class investing – or at least implementation. This has led to a weird distortion over the past decade: Many in the industry who preached Fama-style asset-class diversification and rebalancing often ignored gold while it moved from US$250 to US$2,000.

Second, Fama's observations do not include the phenomenon of central banking. Fama is willing to DESCRIBE the reality of investing – that gains are made by being in the right asset class at the right time – but from what we have seen of the literature, he resolutely refrains from explaining WHY.

We are not so shy as Dr. Fama. To us it is obvious: Asset-class investing works because central bank monetary stimulation drives markets and returns. Various asset classes and instruments will rotate in and out of favor depending on the time and complexity of the business cycle. And the business cycle is driven by money printing.

So … we return to the premise of this article – that economics is observational. What Fama observed, without providing a central-banking explanation as free-market analysis has done, was that asset classes are important repositories of wealth.

But there are other ways to implement Fama's insights. One can set up a "permanent" portfolio, as Harry Browne did. Or one can attempt, via active management, to migrate from one asset class to another depending on the location of the business cycle at a given time.

A third way is simply to use the leverage provided by the securities industry itself. Wall Street bankers make billions based on their ability to bring a company along from start-up to IPO. The upcoming JOBS Act is going to make it possible for people outside of Wall Street to participate in this sort of evolution.

The Daily Bell has been preaching this message in its new incarnation because it removes investors from the inevitable active versus passive debate. The way money is REALLY made on Wall Street is by being IN THE BUSINESS, by taking gains at all levels of the market, from inception to eventual listing.

You won't learn that from Fama, though. Fama is a "favorite son" because he eschews any academic explanation that features an industry analysis. Fama gave bankers and brokers what they want most: elegant, academic models that seem to offer investment solutions based on equations.

It leaves out a discussion of any of the really uncomfortable questions, like why asset returns should be driven by central bankers in the first place. And where are the investors' yachts? Fama's work in practice has yielded up gains for individual investors but they are paltry compared to what can be obtained by being "in the right place at the right time."

Here's a thought: Go back in time to the 20th century and try your hand as a Big Board specialist. That was a ticket to real wealth! Those fellows set the price of their book every morning based on the previous day's order flow. And Big Board rules mandated that they had to make trades based on that insider knowledge …

There are so many ways to make money in the markets as an "insider." Fama's work emphasizes investing as a science, but really it is no such thing. The "industry" of investing is based on enormous money flows generated by central banking.

Fama made investing seem analytical and academic when in fact it is the result of unbridled money flows partially guided by a skein of rules, regulations and lightning fast computer models.

He showed investors how they might eke out a profit in a game they could not control, nor fully understand. But the game remains a "rigged" one and is gradually getting more and more dangerous. There's probably one more stock market blow-off being engineered right now – as we've been pointing out. But after that …

After Thoughts

Are Fama's observations really worth a Nobel? Oh, wait – they're not! …

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