Eugene Fama

Building on the ideas of Bachelier, Cowles, Samuelson, and many others, Fama set out to develop a comprehensive theory to explain why stock market prices fluctuate randomly. He coined the famous phrase "Efficient Market."

Fama worked for a stock market newsletter firm while attending undergraduate school in Boston. One of his duties was to find "buy and sell signals" based on certain market trends. He experienced firsthand the difficulty in predicting future market trends. He began to wonder, just as Cowles did before him, why it was so difficult to translate what appeared to be neatly defined past trends into sure methods of making money in the stock market. These ponderings influenced him enough to attend the University of Chicago, obtain his doctorate, and become a professor teaching classes on the works of Harry Markowitz. Despite the innovative character of Markowitz's writings and his association with Chicago, his work was virtually unknown when Fama first brought it to the attention of the finance department. Fama later applied his extensive, world famous research to create numerous index mutual funds at Dimensional Fund Advisors.

In January 1965, the Journal of Business published Fama's entire 70-page Ph.D. thesis, The Behavior of Stock Market Prices, summarized nine months later by the Financial Analysts Journal and titled "Random Walks in Stock Market Prices". Fama suggested that by utilizing the tremendous resources that a major brokerage firm can muster for researching industry trends, effects of interest rates, accounting data, and by talking to managers of firms, consulting economists and politicians, a security analyst should be able to consistently outperform a randomly selected portfolio of securities of the same general risk.

Since in any given situation, the analyst has a fifty percent chance of outperforming the random selection, even if his skills are nonexistent, Fama's conclusion was that the analysts do not consistently outperform a market.

These analysts do help keep the market efficient. If all investors held portfolios of index funds, opportunities would open for active traders to take advantage of the indexed investors. As more active traders moved in to exploit these opportunities, the index advantage would be extinguished and Fama's Efficient Market Theory would once again be evident.

The Efficient Market Theory explains the workings of free and efficient financial markets. Information about stocks is widely and cheaply available to all investors. All known and available information is already reflected in current stock prices. The price of a stock agreed on by a buyer and a seller is the best estimate, good or bad, of the investment value of that stock. Stock prices will almost instantaneously change as new unpredictable information about them appears in the market. All of these factors make it almost impossible to capture returns in excess of market returns, without taking greater than market levels of risk.

It is relatively rare to find and profit from a mismatch between a stock's price and its value, or to identify an undervalued or overvalued stock through fundamental analysis of stocks. This creates efficient financial markets where most stock prices accurately reflect their true underlying investment values. Even when stock prices do not reflect their values, attempts to establish more accurate values usually cost more than the profit to be made from successful efforts to do so.

This theory threatens the view that there might be something pinning down the average price of an asset. Deviations of an asset price from this value follow a random walk. This annoyed those who claim that they could anticipate speculative trends in asset prices. They could not beat a market, because any available information is already incorporated in the price.

Anyone with evidence to the contrary has yet to show a comparably rigorous analysis of the facts. At the 1968 Institutional Investor conference, one irate money manager insisted that what he and others did for investors had to be worth more than just throwing darts at the Wall Street Journal. The "dart board portfolio" soon became a new benchmark for active investors, appearing in newspapers, magazines, and in a 1992 20/20 ABC news segment entitled, Who Needs the Experts? In that segment, a giant wall-sized version of the Wall Street Journal was made into a dartboard. Reporter John Stossel threw several darts as he described the firms he randomly hit. The results of that portfolio were compared to those of the major Wall Street Firm experts. The darts beat 90% of the experts! When ABC requested interviews with several of these expert firms, not one of them would speak or comment on their humiliating inability to beat the darts.

The Random Walk Theory of stock market prices was detected as early as 1900 by Louis Bachelier and in later studies by Holbrook Working (1934), Alfred Cowles (1933, 1937), Clive Granger with Oskar Morgenstern (1963), and Samuelson (1965). Fama took the theory to new heights with enough rigorous statistical analysis to shake up Wall Street.

The biggest problem in getting this information out to the public was that nobody had figured out a way to convert this academic research into a practical product. The entire investment industry profited from the active trading of investment portfolios; even the mutual funds were just very large actively traded portfolios. Today there are index funds incorporating virtually all the research described in this time line.