The popularity of index funds among sophisticated investors owes much to Eugene Fama’s efficient market hypothesis. Markets are efficient when stock prices incorporate all available public information. The key implication of Fama’s theory is that if markets are efficient, expert stock pickers won’t on average outperform the market unless the experts have inside information or are willing to take on extra risks by holding stocks that make a broad-market portfolio more volatile. If you think Fama deserved his Nobel, you should probably avoid paying high fees to actively managed mutual funds.
Bob Shiller, the second Nobel winner, helped develop the Case-Shiller home price index that tracks the average value of homes in different markets. As you can really only study that which you measure, this index has done much to advance understanding of the housing industry, with one conclusion being that your home is not a safe asset, since housing prices can fluctuate greatly over the long term.
Bob Shiller’s other research on asset price fluctuations in some ways comes to the opposite conclusion of that of Fama. You ultimately want to own stocks so that you can collect dividends, yet Shiller found that stock prices vary far more than do changes in dividends. Shiller investigated this paradox and concluded that stock prices respond too much to new information, perhaps because of speculative bubbles and irrational investor behavior. If Shiller is correct, you could profit from assuming that stocks will overreact to new information. This, however, is a very risky strategy that I doubt many investors would succeed in profiting from, at least if they don’t understand the “generalized methods of moments.”
Of the three men who shared the economics Nobel, I understand Lars Hansen’s research the least even though he was the only one I had as an instructor. Hansen’s most important work was devising a statistical technique called the “generalized methods of moments,” which requires fewer arbitrary assumptions than other techniques do. I recall from graduate school someone telling me that if you learn Hansen’s method, you can earn a lot of money because the method is valuable to Wall Street financiers. I would bet that hedge funds that profit from finding market price inefficiencies employ people who, unlike me, really do understand Hansen’s statistical tools.
So if an investment adviser assures you that he can outperform the market by finding inefficiencies, ask him whether he understands the generalized method of moments. Such understanding should be a minimum bar for him to have your trust.