Eugene Fama is a Nobel laureate in Economic Sciences and is often referred to as the father of modern finance. But if it weren't for a summer job he took as an undergraduate student at Tufts University, he may never have studied finance at all.

Fama actually majored in Romance Languages, but a temporary position at a stock market newsletter piqued his interest in the financial world. The newsletter tasked its young recruit with evaluating stock prices and finding "buy and sell signals" for investors to act on. What Fama found was that price movements were extremely difficult to predict, and it sparked his curiosity about how stock prices are determined.

As a result, after completing his undergraduate degree, Fama decided to shift his focus to economics. For his graduate studies he enrolled at Chicago Business School. There, under the mentorship of influential economists like Merton Miller and Harry Roberts, he developed a keen interest in the empirical analysis of financial markets.

"My generation came along at the right time," Fama explains in a new online documentary called Tune Out the Noise. "Data was starting to be generated. Nobody had touched the data. So whatever you did was new. It was like shooting fish in a barrel."

The Efficient Market Hypothesis 

It was at Chicago in the 1960s that Fama worked on the first of two major contributions he has made to academic finance — his development of the Efficient Market Hypothesis (EMH). Simply put, EMH asserts that financial markets are "efficient" in reflecting all available information about publicly traded assets. Because all relevant information is already factored into prices, no investor can consistently achieve higher returns on a risk-adjusted basis than another investor who simply holds a random portfolio of diversified stocks.

In his 1970 paper Efficient Capital Markets: a Review of Theory and Empirical Work, Fama identified three different types of market efficiency.

1. Weak Form Efficiency This form asserts that all past market prices and data are fully reflected in asset prices. In a weakly efficient market, technical analysis (which relies on patterns in historical price movements and volumes) would not be a useful tool for predicting future price movements.

2. Semi-strong Form Efficiency This level of efficiency claims that all publicly available information is fully reflected in asset prices, not just past prices. Consequently, fundamental analysis (which examines company earnings, industry conditions, and other economic factors) would also be ineffective in predicting future price changes.

3. Strong Form Efficiency: The strongest form of market efficiency states that all information, public and private (insider information), is completely integrated into stock prices. In a strongly efficient market, even insiders possessing material non-public information would be unable to profit from this knowledge.

It's hard to overstate how ground-breaking EMH was at the time or how disruptive to the financial industry it remains to this day. If the market is truly efficient, then no investment strategy, whether it's based on technical analysis, fundamental analysis, or even insider information (in the strong form), can consistently outperform an investor who simply buys and holds a diversified portfolio.

Because beating the market is virtually impossible through either skill or information advantage, the logical conclusion for investors today is that they are better off investing for the long term in index funds or passively managed ETFs that simply aim to replicate market indices.

EMH has arguably had a bigger influence on investing and asset management than any theory in finance; you only need to look at the extraordinary growth of indexing in recent decades to see the difference it has made. A 2014 paper called Gene Fama's Impact: A Quantitative Analysis, G. William Schwert and Rene M. Stulz concludes that "Gene Fama has been the most prominent empiricist in finance for 50 years."

"The efficient markets view," the authors went on, "inspired countless laws, regulations, accounting practices and policies ... It affects how investors make their investment decisions and evaluate their performance."

Different dimensions of risk

 It would be wrong to assume, however, that Eugene Fama views traditional indexing as the optimal way to invest. It is, in his view, a superior strategy to active investing — in other words, trying to outperform the market by buying and selling the right assets at the right time. But better still, Fama argues, is to seek exposure to specific types of risk that have been rewarded with higher returns in the past.

"Markets are efficient," Fama said in an interview after receiving the Nobel Prize in 2013, "but there are different dimensions of risk and those lead to different dimensions of expected returns. That's what people should be concerned with in their investment decisions and not with whether they can pick stocks."

What Fama was referring to in that statement is the research he has conducted over many years with Kenneth French into the factors that drive investment returns. Fama and French demonstrated that the only way investors can expect to beat an index return is by taking greater risk than the index. Specifically, they posited in a 1992 paper, called The Cross-Section of Expected Stock Returns, they needed to increase exposure to small and value stocks.

"In that paper," Mark Hebner writes in Step 2 of his book Index Funds: The 12-Step Recovery Program for Active Investors, Fama and French determined that exposure to market, size, and value risk factors explained as much as 96 percent of historical returns in diversified stock portfolios. Their discoveries serve as the foundation for constructing their own research indexes that capture risks and returns based on the multiple factors for equities and fixed income."

Fama and French later added two more factors to their original Three-Factor Model — profitability and investment. In other words, stocks of companies with high profitability generally provide higher returns than those of companies with lower profitability, and firms that invest conservatively tend to outperform those that invest more aggressively.

Research conducted by Fama and French also shows that longer-term bonds tend to have higher yields than shorter-term bonds, while bonds with a higher risk of default usually offer higher yields than those with a lower risk of default.

Lessons for investors

 What lessons, then, can ordinary investors learn from Eugene Fama? I suggest there are three main ones:

1. Accept that markets are broadly efficient. Yes, it's possible to make the case that markets are not perfectly efficient; as Eugene Fama himself likes to point out, EMH is only a hypothesis. But the point is, markets are efficient enough to make them very hard to beat. The vast majority of active fund managers fail to beat the market on a properly cost- and risk-adjusted basis. What's more, identifying in advance those very few managers who will outperform in the future is exceedingly hard. So the best policy is to avoid concentrated active bets altogether and stay broadly diversified instead. 
2. Take the right kinds of risk. Although EMH implies a random daily movement of asset prices, the stock returns that are realized over long periods of time reflect the risks of those stocks, and those risks are embedded in prices by market participants. Remember, some types of risk have been better rewarded in the long run than others. There is no guarantee that increasing your exposure to those specific risk factors will enable you to beat the market in the future, but the empirical evidence shows that doing so gives you the best possible chance of a successful investment outcome.
3.  Use an advisor who understands statistics. Finally, Fama is renowned for his emphasis on empirical analysis and has consistently highlighted the importance of robust data and methodological rigor. So, before deciding to work with a financial advisor, make sure that they understand statistics and have a healthy respect for empirical data. This will enable them to identify the optimal asset allocation for you and to choose funds that maximize the expected return for the level of risk you have the capacity to take. 

If you want to learn more about Eugene Fama, you will find this article by Mark Hebner and this one by Murray Coleman highly informative., and here's a link to 14 interviews and presentations that Fama has given over the years.

 

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ROBIN POWELL is IFA's Creative Director. He always works as a freelance journalist and author, and as Editor of The Evidence-Based Investor.

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