What Two Economists Know About the Stock Market That You Don't

The stock market solved by two economists remains one of the most overlooked breakthroughs in investing history. Their groundbreaking research changed how we understand risk and returns fundamentally. Yet most investors continue making the same mistakes that get pricey. What the two men who solved the stock market found can reshape your investment approach entirely.

This piece explores who these economists are and the revolutionary paper that changed everything. You'll learn what their research reveals about diversification and the risk-return relationship. We'll show you how to apply their insights to your portfolio.

The Two Economists Who Solved the Stock Market

Harry Markowitz sat in the University of Chicago library in 1950, searching for a dissertation topic. He stumbled upon a problem that would change investing forever at 23 years old. While waiting to meet with his advisor, he struck up a conversation with a stockbroker who suggested he study the stock market. That casual encounter led to research that would earn him a Nobel Prize four decades later.

Who Are These Economists?

Harry Markowitz began his groundbreaking work as a 24-year-old graduate student at the University of Chicago. He published a paper on portfolio selection in 1952 that would alter how investors think about risk and return. His contribution was so big that he received the Nobel Memorial Prize in Economic Sciences in 1990, nearly four decades after his research.

Markowitz's insight seemed simple on the surface. Portfolio theory, as he later described it, says, "Don't concentrate all your investments in one place." But this common-sense advice masked a sophisticated mathematical framework that no one had expressed before. He recognised a critical trade-off between average return in the long run and return variability. So he worked on the mathematics of risk-return trade-off and created what would become Modern Portfolio Theory.

The path to his breakthrough came after Markowitz found a disconnect between investment theory and practice. Bringing theory in line with practice meant searching for a way to express the change in expected values of dividends mathematically while accounting for related risks. This search led him to look at variants and standard deviations of weighted sums in mathematical probability texts. That moment in the library sparked his revelation: a portfolio's volatility depends not only on the volatility of its individual parts but also on how much they move together.

Eugene Fama emerged as another pivotal figure in understanding financial markets. The University of Chicago professor became known as the 'father of modern finance. 'Fama developed the efficient market hypothesis, which says that a stock's price reflects all available information, such as a company's earnings or a potential merger. His work began in the mid-1960s and built on the foundation that Markowitz had created.

Fama's research, alongside several collaborators, showed that stock prices are difficult to predict in the short run. Their findings showed that prices incorporate new information rapidly. These findings not only had a profound effect on later research but also changed market practice. The rise of index funds in stock markets across the world stands as a clear example of how Fama's work translated into real-life investment products.

Three American professors received the Nobel Prize in Economics in 2013, recognising decades of research that began in the 1960s. Eugene Fama and Lars Peter Hansen, both from the University of Chicago, shared the prize with Robert Shiller of Yale University. The Royal Swedish Academy awarded them for their empirical analysis of asset prices. These laureates laid the foundation for the current understanding of asset prices. Their work relies in part on fluctuations in risk and risk attitudes and in part on behavioural biases and market frictions.

The three economists pursued their theories independent of one another, yet their combined research laid the groundwork for two major developments in finance: the rise of index funds and the field of behavioural finance, which takes investors' motivations and limitations into account. The Nobel Prize came with a cash award of 8 million Swedish kroner, slightly more than 1.15 million euros.

Lars Peter Hansen contributed by developing a statistical method suited to testing rational theories of asset pricing. Hansen and other researchers found that modifications of these theories go a long way towards explaining asset prices using this method. His work provided the tools needed to test whether markets behave rationally or whether other factors affect price movements.

Robert Shiller offered a different perspective. He found that stock prices fluctuate much more than corporate dividends. Moreover, the price-dividend ratio tends to fall when high and rise when low. This pattern holds not only for stocks but also for bonds and other assets. Shiller's scepticism about market efficiency led him to argue that the stock market reflects psychology more than it does fundamentals. His warning about "irrational exuberance" in 1996 expressed how markets can develop bubble characteristics at the time people see prices rising and regret not buying in earlier.

The Paper That Changed Everything

Markowitz introduced Modern Portfolio Theory, the mean-variance framework, in his 1952 paper. He later received the Nobel Memorial Prize in Economic Sciences for this work. The paper represented a radical departure from how investors had thought about building portfolios before.

Investors focused on selecting individual securities they believed would perform well before Markowitz's work. They assessed stocks in isolation and looked at each company's prospects independently. Markowitz changed this paradigm by showing that you cannot view items in isolation. You have to look at the relationships between them, whether discussing the relationship between GNP in different countries or two stock markets in the same country.

The mathematics behind his theory revealed something counterintuitive. Standard investment wisdom suggested that adding risky assets to a portfolio would increase overall risk. Markowitz proved that this thinking was flawed. Assets tend to move together, and this determines how much you can reduce risk. Nobody had looked at these correlations and their effect on portfolio risk until Markowitz's work.

His long-time friend Martin Gruber captured the broader meaning: Markowitz's work had a major effect on economics because it showed that relationships between components matter more than the components themselves. This insight extended far beyond investment management into economic theory.

The practical application of Markowitz's mathematics required big computational power. He published his paper and received the Nobel Prize almost four decades later. During that time, he founded portfolio theory, affected how academic research treated portfolio diversification, and changed risk assessment of financial investments. He also ran a business, consulted others, and even developed the computer programming language SIMSCRIPT.

Finding the mathematics of risk-return trade-off meant understanding that investors face competing objectives. Higher expected returns come with higher volatility. Lower volatility means accepting lower returns. Markowitz's framework provided a systematic way to guide this trade-off based on individual risk tolerance and investment goals.

The mean-variance analysis that Markowitz popularised had appeared earlier in the academic literature. Bruno de Finetti published the mean-variance analysis method in 1940 in the context of proportional reinsurance, though under a stronger assumption. However, Markowitz's work brought these concepts into mainstream finance and established a connection between portfolio risk, expected return, and asset pricing in equilibrium.

Fama's research complemented Markowitz's portfolio theory by looking at how markets process information. Markowitz showed how to construct optimal portfolios, while Fama showed why beating the market through stock selection proves so difficult. His efficient market hypothesis suggested that because information is incorporated into prices quickly, investors who try to profit from that information after it becomes public will deem it futile.

Stocks returned nearly 7 per cent more per year than bonds between 1926 and 1999. This gap between stocks and bonds, known as the equity premium, presented another puzzle that occupied economists' attention. Rajnish Mehra and Edward Prescott revealed this puzzle in their famous 1985 article, "The Equity Premium: A Puzzle." Standard theory suggested that stockholders should receive perhaps a 1 per cent greater return from stocks than from safer bonds to compensate for the larger risk inherent to equity investing. The actual premium proved much larger than theory predicted.

This equity premium puzzle drew attention from the discipline's brightest minds for over two decades. Narayana Kocherlakota of the Minneapolis Fed observed in 1996 that the large equity premium remained a mystery to economists. Later efforts made some progress, but no single explanation gained wide acceptance during that period.

Why Their Work Matters Today

The research from these economists continues to shape how you invest money today. Their findings showed that while predicting asset prices in the short term is difficult, they can predict prices in broad terms over longer periods. This work resulted in the rise of stock index funds, which now manage trillions of pounds worldwide.

Index funds exist because of the research showing that stock prices are difficult to predict in the short run. Fama and his collaborators showed that prices rapidly incorporate new information, making it difficult to beat the market by picking individual stocks. Passive investing through index funds emerged as a logical response to this reality.

The effect on market practice extended beyond just index funds. Professional money managers now use concepts from Modern Portfolio Theory when building portfolios. Asset allocation decisions—how much to invest in stocks versus bonds versus other asset classes—follow from Markowitz's insights about correlation and diversification.

Risk management practices across the financial industry owe a debt to these economists. Banks, pension funds, insurance companies and other institutions use mean-variance analysis and related techniques to assess and manage portfolio risk. The mathematics that Markowitz developed in 1952 now supports risk management systems processing billions of transactions daily.

More than two-thirds of households held no stocks at all until the 1990s, while the richest 1 per cent held almost half of all equity. By 2002, half of households owned some stock, but a small number of people held most of the equity. This change towards broader stock ownership came in part from an understanding of the long-term benefits of equity investing, as shown by research from these economists.

The behavioural finance field that Shiller helped create now affects everything from product design to regulatory policy. Recognising that investors don't always behave rationally—that psychology matters—has led to breakthroughs such as automatic enrolment in retirement plans and default investment options designed to protect people from their own behavioural biases.

Researchers continue to use Hansen's statistical methods to test theories about how markets work. His techniques allow economists to assess whether rational theories explain asset prices or whether they need modifications. This ongoing research helps refine our understanding of market dynamics and investor behaviour.

The connection between these economists' work and your investment returns is direct. You're applying Fama's research showing that markets incorporate information efficiently if you invest in index funds. You're using Markowitz's insight about correlation reducing risk if you broaden across multiple asset classes. If you avoid chasing hot investment trends, you are heeding Shiller's warnings about irrational exuberance.

Professional investors who ignore these findings risk serious consequences. Many studies have indicated that most active fund managers fail to beat their standards after accounting for fees. This outcome lines up with what the efficient market hypothesis predicts. Managers who outperform in one period rarely repeat that success, suggesting luck rather than skill often explains the difference.

The implications extend to how you should consider risk. Risk was poorly defined in investment contexts before Markowitz. His work gave us precise mathematical tools to calculate risk through variance and standard deviation. He showed that total portfolio risk depends on how assets move relative to each other, not just on their individual volatilities.

Stock market bubbles, which Shiller studied, continue to form despite decades of research warning about them. His observation that stock prices fluctuate much more than corporate dividends expresses how psychological factors drive prices away from fundamental values. Housing bubbles in various countries showed that these patterns repeat across different markets and times.

The equity premium research, while not fully solved, provides context for long-term investing decisions. Understanding that stocks have returned about 7 per cent more per year than bonds helps you make informed choices about asset allocation. But this premium compensates you for taking on additional risk, and the returns vary in the short run.

Academic research building on these foundations continues today. Modern portfolio theory has been refined and extended, but the core insights remain valid. New statistical techniques improve our knowing how to estimate correlations and forecast volatility, yet they rest on the mathematical framework Markowitz created.

What Their Research Reveals About Investing

Most investors believe they understand diversification because they own multiple stocks or funds. But what the two men who solved the stock market found reveals that true diversification works in ways that contradict common assumptions. The mathematics behind their research exposes critical gaps between how people think portfolios should behave and how they perform.

Diversification Isn't What You Think It Is

Markowitz introduced his foundational concept in investment analysis in 1952. He emphasised the benefits of portfolio diversification and suggested that you can alleviate risk by holding a diversified mix of assets. Yet the principle extends far beyond collecting a variety of securities. The approach that works for you depends on factors like your goals, time horizon and risk tolerance.

Diversification helps lower your overall investment risk by tapping into a concept known as correlation. Correlation shows how different investments move compared with one another. Your portfolio has low correlation when you combine investments that don't move in the same way, which can protect against extreme declines. This represents the core insight that separates effective diversification from owning many things.

Assets tend to move together to some extent. The degree to which they move together determines how much you can reduce risk. True diversification means owning stocks from various industries, countries and risk profiles. It also means investing in other asset classes beyond equities, such as bonds, commodities and real estate, whose performance isn't in sync with stocks during different market environments.

Research reveals interconnectedness among asset classes over long timelines, from 2014 to 2024, highlighting the critical role of diversified investment strategies in managing portfolio risk. MSCI equity indices show strong interconnectedness, while bonds exhibit bidirectional volatility with equities. Brent and commodity indices drive spillovers to natural gas, while the Baltic Dry Index remains isolated. Gold acts as a hedge and links to commodities and bonds, whereas Bitcoin remains disconnected from traditional markets.

Analysts measure the quality of diversification in your portfolio by analysing the correlation coefficient of pairs of assets. Studies and mathematical models show that maintaining a well-diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk reduction. Investing in more securities generates further diversification benefits, but it does so at a diminishing rate of effectiveness.

The optimal range differs for those investing through funds rather than individual stocks. Analysis of private fund portfolios with a three-year commitment period found an optimal range of 25-30 and 40-45 funds for pure buyout and venture programmes. Updated analysis shows that 20-25 funds is the optimum size for a portfolio diversified across different stages, vintages and geographies.

Adding more than six funds offers little diversification benefit and reduces the chance of top-quartile returns. The addition of more funds to a portfolio reduces its active risk, which is beneficial to some extent as it reduces the risk of underperforming peers. But it also decreases the probability of the portfolio achieving top quartile performance.

This situation presents a critical trade-off. Over-diversification can affect performance negatively. The more holdings a portfolio has, the more time-consuming it can be to manage and the more expensive, since buying and selling many different holdings incurs more transaction fees and broking commissions. More fundamentally, diversification's spreading-out strategy works both ways and lessens the risk and the reward.

You've invested equally among six stocks, and one stock doubles in value. Your original stake in that stock is now worth twice as much. You've made a lot, sure, but not as much as if your entire investment had been in that one company. By protecting you on the downside, diversification limits you on the upside, at least in the short term.

Diversification is more about risk management than about maximising returns. It aims to reduce the volatility and potential losses in a portfolio rather than hindering or boosting returns. Diversification aims to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments neutralises the negative performance of others.

The benefits of diversification hold only if the securities in the portfolio are not correlated, that is, they respond differently, ideally in opposing ways, to market influences. Diversification maximises its benefit when assets are negatively correlated, meaning their returns move exactly opposite to each other. In this scenario, you can theoretically eliminate all portfolio risk. Conversely, the benefit of diversification is minimised when assets are positively correlated, as their returns move in tandem, resulting in a portfolio that mirrors the risk of the individual assets without any risk reduction.

Selected commodities like oil and natural gas drive global inflation dynamics, energy markets, and broader macroeconomic cycles. They are used as hedging instruments in both institutional and retail portfolios. Alternative assets like gold, Bitcoin, REITs and the Baltic Dry Index provide exposure to non-traditional sources of risk and return. These assets have attracted growing interest from investors seeking diversification beyond equities and bonds during periods of market stress.

The effect of bond volatility on commodities, Bitcoin and gold is minimal, underscoring their role as stable asset classes with limited internal volatility effects. Gold and Bitcoin are regarded as hedges against financial or monetary shocks due to their non-correlated or weakly correlated nature with traditional financial assets.

Both REITs and certain equity indices show a moderate to high sensitivity to equity market volatility, North American equities in particular. REITs and these indices show lower spillovers between each other, suggesting that while they are influenced by similar factors, their internal market dynamics are different.

The Risk-Return Relationship Explained

The risk-return tradeoff has been a longstanding topic in finance. Pricing models for capital assets imply a positive risk-return relationship in the stock market; that is, higher risk is associated with greater expected return. According to this principle, invested money can render higher profits only if you accept a higher possibility of losses.

Using this principle, individuals associate low levels of uncertainty with low potential returns and high levels of uncertainty or risk with high potential returns. The appropriate risk-return tradeoff depends on a variety of factors that include your risk tolerance, your years to retirement and the potential to replace lost funds.

Time also plays a role in determining a portfolio with the appropriate levels of risk and reward. For example, long-term equity investment can help you recover from bear market risks and benefit from bull markets. But if you can only invest in a short time frame, the same equities have a higher risk proposition.

The total risk of a portfolio has two types: unsystematic risk and systematic risk. If you have a large enough portfolio, it is possible to eliminate the unsystematic risk. But the systematic risk will remain.

Unsystematic or specific risk refers to the effect on a company's cash flows of random events like industrial relations problems, equipment failure, research and development achievements, changes in the senior management team and similar factors. Such random factors tend to cancel as the number of investments in the portfolio increase.

Systematic or market risk covers general economic factors that affect the cash flows of all companies in the stock market in a consistent manner, such as a country's rate of economic growth, corporate tax rates, unemployment levels and interest rates. Since these factors cause returns to move in the same direction, they cannot cancel out. Therefore, systematic or market risk remains present in all portfolios.

A well-diversified portfolio shows dramatic risk reduction by investing in just 15 different companies across various market sectors, benefiting from most of the risk reduction effects of diversification. Two thirds of an investment's total risk can be diversified away, while the remaining one third cannot.

Total risk can be divided into systematic risk, which affects all market participants and cannot be eliminated through diversification, and unsystematic risk, which is firm-specific and can be alleviated by holding a diversified portfolio. As you increase the number of securities in your portfolio, unsystematic risk can be eliminated. But you cannot diversify away systematic risk because, by definition, it affects all companies.

Unsystematic risk is eliminated in portfolios of thirty-plus randomly selected stocks. You are only rewarded for bearing systematic risk, as this type of risk is the only kind that cannot be eliminated through diversification.

Different asset classes come with varying levels of investment risk. Having investments with different risk-return profiles helps meet the varying risk appetites of different investor groups. Risk-free bonds issued by governments are considered safe since a government can print money to pay off its debts. Because of this, risk-free bonds are the safest asset and have the lowest investment return.

Moving up the risk-return spectrum, each asset class becomes riskier, but the potential investment return associated with each asset class also increases. Private equity firms invest in private companies that are not traded on an exchange, and they carry more risk than public equities. It has additional risks such as liquidity risk. But because of these additional risks, private equity also offers the highest potential investment returns.

Higher investment returns can only be generated by taking on higher investment risk. But this principle does not apply in every single scenario. To name just one example, by diversifying a portfolio of investment assets, a comparable return can often be generated with less risk than an undiversified investment portfolio.

The risk and return trade-off should be a primary consideration when determining your strategic asset allocation. To name just one example, if you're saving for retirement with a specific real required return, you should select an asset mix that meets or exceeds that amount, with an acceptable corresponding risk of potential loss. If you do not meet either of those requirements, you may need to revisit them.

Inflation risk is often overlooked and can have a major effect on asset-class returns and change the portfolio's risk profile. This is one reason why cash does not play a role in a diversified portfolio with long investment horizons. Rather, cash should be used to meet liquidity needs or be integrated into a portfolio designed for shorter horizons.

Being too conservative could be just as damaging as being too aggressive. If you're too conservative, you may lack the growth potential to reach your goals or outpace inflation. Conversely, if you have too much risk, you'll experience a lot more market volatility, which could lead you to jump out of the market at a particularly inopportune time.

Why Most Investors Get It Wrong

Investors often make choices based on behavioural finance biases, fear or overconfidence in their investment behaviour, and these factors lead to poor outcomes and irrational savings behaviour. Understanding these factors can improve investment strategies.

Loss aversion is a core principle of behavioural economics. It suggests that people feel the pain of losses more than the pleasure of gains. This principle often leads you to hold onto losing stocks too long and hope for recovery. You fear realising a loss more than you desire potential gains.

Overconfidence is another concept. Many investors overestimate their knowledge or capacity to predict market movements. Research shows that this bias can lead to excessive trading and poor investment choices. An overconfident investor might ignore warnings about a stock's downturn and believe they can time the market. Such behaviour often results in financial losses.

Herding behaviour occurs when individuals mimic the actions of a larger group. You often follow trends without conducting your own analysis. To name just one example, during a market rally, many might buy stocks because others are doing so. This can inflate stock prices beyond their actual value and lead to bubbles. When the bubble bursts, panic selling can ensue and cause widespread losses.

Anchoring is a cognitive bias where you rely too heavily on the first piece of information you receive. This could be the initial price of a stock in finance. If you buy a stock at a certain price, you might anchor your expectations to that price. Even if the stock declines, you may refuse to sell, believing it will return to its original price.

The worst mistakes include failing to set up a long-term plan, allowing emotion and fear to influence your decisions and not diversifying a portfolio. Other mistakes include falling in love with a stock for the wrong reasons and trying to time the market.

Trying to time the market also kills returns. Timing the market is very difficult. Even institutional investors often fail to do it. Market timing is possible, but very hard. Trying to make a well-timed call can be their undoing for people who are not well trained. An investor who was out of the market during the top 10 trading days for the S&P 500 Index from 1993 to 2013 would have achieved a 5.4% annualised return instead of 9.2% by staying invested. This difference suggests that you are better off contributing to your investment portfolio rather than trying to trade in and out in an attempt to time the market.

A prominent study, 'Determinants of Portfolio Performance', conducted by Gary Brinson, L. Randolph Hood and Gilbert Beebower, covered American pension fund returns. This study showed that, on average, nearly 94% of the variation of returns over time was explained by the investment policy decision. Most of a portfolio's return can be explained by the asset allocation decisions you make, not by timing or even security selection.

How your assets are allocated across different asset classes can provide a solid foundation upon which your portfolio may

Final Thoughts

The research from Markowitz and Fama changed investing, yet most people still ignore their findings.

True variation depends on the correlation between assets, not on owning many stocks. You cannot eliminate systematic risk, so focus on asset allocation rather than picking individual securities or timing the market. Behavioural biases will tempt you to make mistakes that get pricey. Index funds exist because beating the market proves impossible.

Your investment success depends on applying these insights: vary your holdings, accept appropriate risk for your goals and avoid emotional decisions. Asset allocation accounts for 94% of your portfolio's returns, so please prioritise getting that decision right first.

FAQs

Q1. Can understanding economics help you make better investment decisions?

Understanding economics can aid in understanding market trends and risk assessment, but it doesn't guarantee better investment outcomes. Research shows that most professional fund managers fail to beat market indices consistently, suggesting that economic knowledge alone isn't sufficient for outperformance. However, it can help you avoid common mistakes and make more informed long-term decisions about asset allocation.

Q2. Why do economists often struggle with short-term stock market predictions?

Economists tend to focus on macro-level trends and rational market behaviour, but investor psychology, sentiment, and unpredictable events heavily influence short-term stock movements. Markets can remain irrational longer than we anticipate, and economic fundamentals often disconnect from daily price action. This is why many economists advocate for long-term, diversified investment strategies rather than active trading.

Q3. Is it better to invest without economic knowledge?

Whilst some investors succeed without formal economic training, a basic understanding helps you avoid catastrophic mistakes and recognise unsustainable trends. The key isn't necessarily deep economic expertise but rather discipline, emotional control, and a sound investment strategy. Many successful investors combine practical experience with fundamental knowledge rather than relying solely on economic theory.

Q4. Do people with economics degrees outperform the stock market?

Studies indicate that economists and finance professionals don't consistently beat market indices over the long term. In fact, overconfidence in one's economic knowledge can lead to poor timing decisions and excessive trading. The most successful approach for most investors is typically a diversified, low-cost index fund strategy rather than attempting to outsmart the market.

Q5. What's more important for investing success: economics knowledge or emotional discipline?

Emotional discipline and behavioural control are arguably more critical than economic expertise. Many investors with strong economic backgrounds still make poor decisions driven by fear, greed, or overconfidence. Understanding behavioural biases, maintaining a long-term perspective, and avoiding emotional reactions to market volatility often matter more than the ability to analyse economic data.

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