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2012-03-19 12:03:25
January 14 2008 | Filed Under Economics , Financial Theory , Futures , Options
The Nobel Memorial Prize in Economic Sciences doesn't necessarily recognize the newest or most "cutting edge" ideas within economics and finance, but instead focuses on those that employ a more wait-and-see approach. After all, Merton and Scholes didn't get their prize until 1997, long after their option pricing formula had become a ubiquitous tool for traders and portfolio managers.
In this article, we'll take a look at some of the past winners whose contributions are particularly well known and useful to our everyday investing lives.
About the Prize
The late Alfred Nobel didn't decree a prize for economics in his will like he did for literature, physics, chemistry, medicine and peace. The Nobel Memorial Prize for Economic Sciences didn't arise until 1968, when the Bank of Sweden established it on its 300th anniversary in memory of Alfred Nobel.
Also of note, the criteria for the prize were expanded in 1995 to include social sciences as a whole, so that contributions in fields like sociology and political science could also be recognized. They are often intertwined in modern economic theory, as governments, companies and individuals all work to solve the same problems and allocate the same resources.
Lastly, awards can only be given to the living. Alas, for late greats like Adam Smith and John Maynard Keynes, there will be no (well-deserved) posthumous prize.
Economic Theories Take Time to Prove
In economics, more so than most fields, it takes many years for a given theory or discovery to truly be proved effective, or even right. The study of economics, especially macroeconomics, is usually one of trends and cycles, market shocks and hindsight studies. For example, if one's theory is on how inflation responds at the beginning and end of a bull market, it could take 10 years or more to even reach the end of a bull market and historical economic data may be limited or difficult to correlate to the present.
In time, however, economists whose insights truly change the field do get recognized by the committee.Winning the award brings in a nice paycheck (roughly $1.5 million) and possibly some long overdue credit and attention, especially in some of the younger economic fields such as microfinance and behavioral finance.
Past Winners of Note
Many economists never achieve much fame outside the ivory towers in which they operate, but some have made direct contributions to the economics of individual investors and companies. These past winners deserve a special nod for the tools and theories that have helped investors better understand markets and their own portfolios.
Leonid Hurwicz, Eric Maskin, Roger Myerson Provide Framework for Analyzing Market Conditions
All three of the 2007 Nobel Memorial winners have made major contributions to mechanism design theory, which provides a framework for analyzing market conditions under less-than-ideal scenarios. Hurwicz first introduced the theory in the 1960s. His work was later expanded by his college classmates Maskin and Myerson. They were able to expand the range of uses for mechanism design theory to a wide array of financial mechanisms such as international trade, elections and other voting procedures, and even private social institutions whose overarching goals (usually to benefit the broadest number in the best overall way) may not run parallel to the individual goals of their leaders.
Many aspects of the modern economy do not fit neatly into classical definitions of markets, where perfect competition and "equilibrium conditions" always exist. The trio's work has validated the use of auction-style markets for many types of trade and opened up new schools of thought for dealing with social problems and the transmission of public goods.
Samuelson Helps Turn Economics into a Pure Science
Paul Samuelson won the second prize ever awarded in 1970; he was recognized for his game-changing contributions that married economics with mathematics. Before Samuelsson, economists and investors struggled to conduct mathematical and scientific analysis on markets because there was no consistent way to compare situations under different conditions. His 1947 book, "Foundations of Economic Analysis" has sold more copies than any other textbook on economics, and Samuelson is considered one of the founders of modern neoclassical economics. (For more economic concepts, read Economics Basics.)
Milton Friedman Redefines Role of Economics and Government
Milton Friedman won in 1976 for his groundbreaking studies of consumption analysis and monetary theory, and has been considered by some to be the most important economist of the Twentieth century. Friedman advocated a small government and a hands-off approach to markets - theories that became the cornerstone of many political and economic movements beginning in the early 1980s. Friedman believed that markets played an instrumental role in politics and government, so much so that some problems, he stated, could only be solved through the use of market forces.
One of Friedman's biggest fans was Alan Greenspan, who used Friedman's theories on monetary supply and economic output to guide the U.S. economy through a record expansionary period between the mid-1980s and 2006. (For more insight, see A Farewell To Alan Greenspan.)
The 1990 "Investor's Trio": Markowitz, Sharpe and Miller
These three winners may have shared the 1990 prize, but each made extraordinarily useful individual contributions to investors. Harry Markowitz is the godfather of modern portfolio theory, having given us the same theories of mean-variance portfolio analysis that most money managers still use today. His mathematical approach to creating an optimal portfolio opened the door to modern diversification techniques and educated us on the critical tradeoffs between risk and return. (To learn more about the modern portfolio theory, see Modern Portfolio Theory: An Overview and Modern Portfolio Theory Stats Primer.)
Markowitz's ideas were later picked up by William Sharpe to create the backbone of the capital asset pricing model (CAPM), which is used extensively today by both investors and company managers to determine the required level of return on an asset. The success of the CAPM and its associated "Beta" coefficient helped to standardize the process of evaluating assets and their risk premium. (To find out more about CAPM, check out The Capital Asset Pricing Model: An Overview.)
Merton Miller doesn't have the honor of having a financial term named after him (a la the "Sharpe ratio" and "Markowitz efficient frontier", but he brought long-overdue attention to corporate finance and individual investors. His theories have helped guide the way managers run companies on behalf of shareholders; specifically, he was able to prove that because investors can diversify portfolios on their own, companies should simply try to maximize shareholder value and not worry about finding the perfect ratio of debt capital to equity capital.
Derivatives Take Center Stage Merton and Scholes in 1997
The year 1997 brought long-overdue acclaim to the creators of the definitive options pricing mechanism. The Black-Scholes-Merton formula was developed by Robert Merton and Myron Scholes. Fischer Black passed away in 1995. The award came long after Black-Scholes pricing had permeated the world of stock options pricing and terms like "time value" and "the Greeks" were already in the option investor's vocabulary. (To read more about option pricing, see Understanding Option Pricing, Using the Greeks to Understand Options and Getting To Know The "Greeks".)
The three investors' work in standardizing options pricing led to a broad expansion in derivative securities as a whole; futures, employee stock options and commodities have all flourished since. Most importantly, it took an area of finance that had a limited audience and brought it to the world through the common language of mathematics.
Conclusion
Nobel Memorial Prize winners have given us much more than fodder for dissertations and masters' theses; past winners have provided real investors with tools that are used every day and open up new ways to view assets, the markets and our role in making them work. The first step in learning to use these models is to introduce yourself to their creators.
by Ryan Barnes