Most people won’t recognize the name Eugene Fama off the top of their head.
This doesn’t surprise me.
However, Eugene (Gene) Fama won a Nobel Prize in Economic Sciences in 2013. He is often described as ‘the father of modern finance’. His research, spanning the past 50 years at the University of Chicago, has revealed this simple truth: In Dr. Fama’s own words, “The general proposition is quite straightforward. It says prices reflect all available information. That’s it.” As a result, Fama thinks it should be very difficult to consistently outperform the market with the information available at any given time.
Said another way, what drives change in a stock’s price is news. News, by definition is unknowable ahead of time. That’s why it’s called news! News can range from specific information about the company in question, the latest prospects for the economy, news about a competitor in the same industry, or the latest developments regarding a conflict somewhere in the world. Each investor will process all of this news and make a judgment about what they believe to be the true value of the stock, and a transaction happens when a willing buyer and a willing seller agree to a price. Transactions take place about 39 million times every day in markets around the world. As news comes out, prices change.
At a speech I attended by Dr. Fama a few years ago, someone asked him if he believed that stock prices were always correct or perfect like his efficient market hypothesis suggests. He answer was this: history teaches us this hypothesis is obviously not true all the time because there are times when a security trades way above or way below its true value. The efficient market hypothesis does not propose that prices are always perfect. Rather, it concludes that investors should act like prices are accurate, because the current price is the best estimate of future value. For more on this concept, spend two and a half minutes watching the video, How Markets Work.
Fama’s simple (and Nobel Prize-worthy) conclusion begs the question, is trying to select stocks that will outperform the overall market (active investing) a bad thing?
That depends. There is no shortage of academic studies showing that most people pay higher prices for no benefit. However, the active trading of stocks is part of what makes markets so efficient. I like this Chicago Tribune article put it:
“Under Fama’s efficient market hypothesis, even professional portfolio managers won’t beat the market in the long term because of their perceived expertise, and those who believe they can are deluded. This is not a hypothesis that’s popular with the mutual-fund managers who command big fees from customers who believe they can gain an edge.”
Of course, Fama’s conclusions have set off controversies and criticism. But Fama himself admits that investing involves risk, and investors have the freedom to choose who manages their portfolios, and how their portfolios are managed. Ultimately, Dr. Fama’s work has led to the development of the stock index funds that mimic the Standard & Poor’s 500 index, and the funds created by Dimensional Funds Advisors, used by many advisors at Integrated Financial Group, the consortium of independent financial planners that we belong to.
I think Eugene Fama’s Nobel Prize is important to note for several reasons:
- It adds credibility to his research and his contributions to modern finance.
- It affirms that we should take risks where compensation is expected, and avoid the risks where we are not!
- It provides a less stressful way to invest, because the investor understands that all returns, whether up or down, are part of the bigger picture of an efficient capitalist system.
We don’t need to understand Fama’s research in detail, but by understanding the principles and how they apply to us, we’re more likely to avoid making poor financial decisions.
If you want a more in-depth review of Fama’s research, I suggest reading this article by John Cochrane.
Do you have questions about Dr. Fama’s research and resulting investment philosophies? I’d be glad to speak with you. I have had the privilege of hearing both Dr. Eugene Fama and Dr. Ken French speak on their research. Email me at DGaynes@intfingroup.com or call my office at 770-353-6350.
DISCLOSURE
Stock investing involves risk including loss of principal. No strategy assures success or protects against loss.
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