Eugene Fama Nobelist

As an undergraduate Fama worked for a stock forecasting service and he was tasked with coming up with rules to make money in the market. Time and time again he would find profitable rules only to find that they didn’t work in new data or out of sample. In graduate school he started talking to Merton Miller, Lester Telser, and Benoît Mandelbrot and finally hit on the idea that in an efficient market price changes would not be forecastable. The rest is history.

Fama’s dissertation and famous 1970 review article, Efficient Capital Markets: A Review of Theory and Empirical Work made efficient markets a touchstone for modern economists and finance theorists but practitioners hated and still hate the idea. Nevertheless, test after test showed that very few mutual fund managers beat the market and those that beat the market this year are not more likely to beat the market the next year. Chance and perhaps a few, very rare, geniuses explain the data. Eventually, hundreds of billions of dollars began to flow into index funds and today index funds manage over $7 trillion dollars worth of assets worldwide, making Fama the 7 trillion dollar man. Fama’s ideas have made an enormous contribution to how people invest, saving them billions in fees which generated beautiful homes for fortunate mutual fund managers but less than nothing for their customers.

The no free lunch principle is the most robust of the findings of the early Fama/efficient markets school. Other early findings such as non-forecastability of returns have been revised. The initial finding was that returns were not forecastable and that is true for short durations but it is now clear that returns can be forecastable over longer horizons! In particular, variables such as the dividend/price ratio can predict stock return variation years in advance! (Robert Shiller pioneered many of these kinds of studies as did Campbell and Cochrane).  Fama, however, contrary to how he is sometimes represented did not reject these findings. Indeed, the less well known part of the story is that Fama working with French (e.g. Fama and French (1988a,1988b, 1993) has been among the pioneers in documenting and explaining these findings. What Fama’s later work has shown is that many of the anomalies such as time varying returns and the higher return to so-called value firms are real but they are not anomalies they are better explained as variations in risk premia tied to changes in the business cycle.

The CAPM (for which Markowtiz and Sharpe won the Nobel) suggested that the only source of true (priced) risk was risk that varied with the market return. That is one important source of risk but it’s not the only one, other types of macro risk which appear to vary with the business cycle are also priced and they are correlated with markers like the dividend/price ratio and the prospects for value and small-cap stocks. Thus, Fama showed that many of the seemingly anomalies (not all, however!) of the early efficient market tests can be better explained by a market model that incorporates more sources of risk. All of this work has really been a tour de force. It’s not often that the same person creates the theory and then participates in the first revolution overturning (some of) that theory.

Fama also pioneered the first event study! Fama, Fisher, Jensen, and Roll (1969) studied something a bit prosaic, stock splits, but the methodology, looking at how the stock market reacts to unexpected events, has seen been used to study what happens when Senators die unexpectedly (firms they support fall), what happens in close elections, which part was responsible for the Challenger space shuttle crash and many other events.


The name "Efficient-market Hypothesis" is unfortunate because it's referring to the speed at which information is incorporated into forecasts, but is woozy on the accuracy of interpretation of the forecast. A phrase like "Agile-market Hypothesis" might have been better.

Is the Efficient-Markets hypothesis true? One obvious problem with it is that the Forbes 400 is full of zillionaires who beat the market long enough to make the Forbes 400. Were they just lucky? Or is the Efficient Markets Hypothesis wrong? Perhaps you can make so much money in the short run from identifying a major inefficiency, such as the recent subprime unpleasantness, that you can wind up very rich if you have the humility to then retire from placing such big bets?

Or, could it be that the Efficient-Market Hypothesis is right, and a lot of the market beaters beat the market the old fashioned way: by insider trading?

Think of the efficient market hypothesis as the null every time you make a decision.

Not binary- it is true, to some extent.

I don't know why people struggle with the idea of a market for the ability to price securities, or value companies, or visualize opportunities. There's a ton of snake oil out there and these skills are rare, but they exist- Warren Buffett being a singular example.

None of this gainsays Fama.

Indeed, none of it gainsays Fama, but unfortunately the popular view of the EMH is that no one ever anywhere can beat the market, with the result of people naively dumping money into index funds. These people don't really know about, or care much about, the top 1% of performing money managers, many of whom stay in those rankings for decades.

It isn't that the market is efficient, but it's more efficient than the vast majority of market participants.

Yeah again though, this is not a binary and indexing is not unfortunate.

For most people, the market is pretty damn efficient, and that's all that matters to them. The fact that an index exists and allows Joe Sixpack to participate in 'beta' returns- well, that's actually a great deal for Joe Sixpack, who doesn't need to know shit about financial markets to participate. Over the long-term, the 'asset allocation' decision (stocks, bonds, real estate, etc.) produces most of a portfolio's return, not individual security selection. Average people don't belong in sophisticated markets with a bunch of sharpies who do it for a living.

Bashing finance is right up there with bashing government these days, but few people appreciate the value of allowing everyone to free ride on the huge structure of analysis and oversight to which public companies are subject.

When people bash finance, I don't think they intend to criticize those fairly innocuous parts which merely allow average people to invest in public companies.

Joe Sixpack has been given the chance to participate in ‘beta’ returns for a long time now. Those are not the typical targets of finance criticism.


The ability to invest in transparent, low-cost investment vehicles has grown dramatically in the past 40 years. Back then, it was just John Bogle and an idea.

Everyone bellyaches about how this or that 'only works for the 1%'. My point is that the benefits of a modern financial system are manifold and widespread, and the benefits that accrue to regular people from this system are vast- there is no historical parallel.

The sliver you are focusing on is an irksome secondary issue.

"These people don’t really know about, or care much about, the top 1% of performing money managers, many of whom stay in those rankings for decades"

Could you name a few of those people in the 1%?

How does your Forbes 400 factoid question the EMH in any way? EMH doesn't say there's no variance to betting on the market.

What's the ratio of zillionaires to wannabe zillionaires who didn't make it?

Efficient markets depend on knowledge. Being able to arbitrage knowledge can gain you an advantage. That is what the HFT schemes in the stock market do; they know the trades before they occur and arbitrage them.

The zillionaires are either those who use other talents and skills, such as Buffett who buys and manages to profitability. Others are in markets where the instruments are charitably described as opaque. The bond market is like that. Complex financial instruments are another way of saying that no one but the guy who structured it knows what is in it. What was remarkable about the collapse in 2008 was that the large houses on Wall Street had lots of this trashy junk on their books, they couldn't sell it either, but with opacity and a playing of the ratings agencies, managed to make it look more valuable than it was, not for the purpose of selling but for the purpose of borrowing against.

On simple fact to remember about the 'market'. The stock market is dwarfed by the size of the bond and debt instrument market.

"Or, could it be that the Efficient-Market Hypothesis is right, and a lot of the market beaters beat the market the old fashioned way: by insider trading?"

It's important to distinguish the difference between the legal and colloquial definitions of insider trading. For example a multi-billion dollar hedge fund can send some guys to stand outside the docks in Taipei and count how many Nvidia crates get loaded on to a ship. They can use this to estimate what Nvidia's earnings will be before they're released. Does this give them access to data that 99.9% of investors don't have? Of course. Is it legal? Absolutely.

Indeed, they can, which raises the question of why so few bothered to have somebody drive around Sand State exurbs in the mid-2000s and report back on whether the new buyers looked like they were going to be able to pay back their subprime mortgages. Sure, the cast of Michael Lewis's "The Big Short" took sensible steps, but they were closer to the exceptions that validate the generality.

Here's a short story I published in The American Conservative in 2008 set in the once-booming High Desert north of L.A. to give you a feel for what it was like on the ground during the Bush Bubble:

And, yet, the markets, no matter how agile at responding to new information, were very, very bad at responding to an abundance of old information. Which is, of course, why Schiller got the Nobel.

Very readable, entertaining and insightful short story. I think it really gets to the core of the housing bubble.

As someone in the hedge fund industry, here's my take on why shorting the housing market wasn't a good trade. Even if it was blatantly obvious it was a bubble. Think of a hypothetical where you can invest in two managers. Manager X is a very good "big picture thinker," here's very good at cutting through a lot of BS and seeing where things are going over the next decade or so. (Kind of like you, Steve). Manager X will generally have a handful of long-term really good investment ideas at any given times, with a horizon of 3-10 years.

Manager Y is completely the opposite. Totally focused on small details. He has no idea where the economy's going or which country's going to do the best, or even what industries are better investment. But he does have the ability to follow hundreds of companies, drill down into their details. He can tell you why BP's earnings are going to be better than Exxon's next month, or which biotech companies are most likely to get FDA approval. Manager Y has hundreds of different bets on at any given time, and they're pretty much independent of each other since they're based on the idiosyncrasies of each stock. They're also probably paying off a lot quicker since they're mostly about upcoming earnings or announcements.

How do you think the risk/return profile of each manager will look? Manager X will definitely deliver returns, he's definitely getting it right in the long-term. But they'll be a lot more lumpy and you might lose a lot of money in the medium-term. In contrast Manager Y because of the law of large-numbers will have much smoother returns. Which means that it's much safer for Manager Y to take higher leverage, which means he can also generate higher average returns. Even if Manager X is ultimately more certain about his views.

Our society tends to lionize the likes of Manager X. People with big visions who take big bets and prove right. That's why Michael Lewis wrote a book about them. But from an investment standpoint these are the worst people to invest in. John Paulson got the housing bubble right (and maybe more importantly the timing), but you would have done much better to invest with Steve Cohen. He didn't even pay attention to the bubble, because he really doesn't pay attention to anything big picture. But year-in and year-out he grinds very consistent, predictable and low-risk returns.

Drawing this back markets tend to be very efficient on the small-scale. Markets become efficient because the smart players eventually takes all the money from the dumb players. This happens much easier with events that frequently repeat and payoff in the short-term. Company earnings announcements are a good example. They happen all the time and they payoff quick, those who are good at predicting earnings will grow their assets very quickly. Consequently the market is very good at predicting earnings.

But big macro questions are different, especially the types of which have never happened before. We never had a sub-prime housing bubble like we did in the Bush years. Plus we never had the type of structured products like CDOs to bundle risk. So the dumb money was just as likely to be stacked as the smart money. The market never had any "training period" on these type of questions. Hence there's no reason to expect the market to be particularly efficient or even better than an observer off the street.


Thanks. Most helpful.

Allow me to reiterate one large inefficiency in evaluating information: political correctness. The Zero Down Mortgage Era was explicitly articulated in the early 2000s by key figures such as George W. Bush, Angelo Mozilo, and Henry Cisneros as a giant bet on the creditworthiness of minorities, especially Hispanics. Doubters were castigated as bigots. This atmosphere (and the enforcement of it threw anti-discrimination lawsuits) suppressed the written articulation of skeptical views on the heart of the Bush-Mozilo-Cisneros proposition.

Skepticism is still in bad, bad taste, despite the publication over the last three years of numerous studies by economists of house price inflation and defaults that show how much the Bubble and Bust was tied into the growth of the Hispanic population. You'll note that the lessons of the Recent Economic Unpleasantness simply never come up in debate over the Schumer-Rubio immigration bill. In other words, this inefficiency in interpreting data remains strong.

Thus, there is money to be made by people more cunning than me.

If 1 million investor each select 20 stocks at random some of them are bound to look like geniuses.

So does Fama+Shiller = 0??

We are waiting to see if the Fama price of Heritage-DeMint-Cruz et al $25 million cost free speech is priced at $500B or $5 trillion.

Thus an efficient market is one where $25 million equals $0 equals $500B-$5 trillion.

We are waiting to see if you ever say anything intelligent. The bets are no.

We are waiting to see if the Fama price of Heritage-DeMint-Cruz et al $25 million cost free speech is priced at $500B or $5 trillion or $50 trillion.

Thus an efficient market is one where $25 million equals 0 equals $500B-$5-$50 trillion.

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