Eugene Fama shared the 2013 Nobel Prize in Economic Sciences with Robert Shiller and Lars Peter Hansen. The three received the prize for “for their empirical analysis of stock prices.”
Fama has played a key role in the development of modern finance, with major contributions to a broad range of topics within the field, beginning with his seminal work on the efficient market hypothesis (EMH) and stock market behavior, and continuing on with work on financial decision making under uncertainty, capital structure and payout policy, agency costs, the determinants of expected returns, and even banking.
His major early contribution was to show that stock markets are efficient (See efficient capital markets). The term “efficient” here does not mean what it normally means in economics—namely, that benefits minus costs are maximized. Instead, it means that prices of stocks rapidly incorporate information that is publicly available. That happens because markets are so competitive: prices now move on earnings news within milliseconds. If someone were certain that a given asset’s price would rise in the future, he would buy the asset now. When a number of people try to buy the stock now, the price rises now. The result is that asset prices immediately reflect current expectations of future value.
One implication of market efficiency is that trading rules, such as “buy when the price fell yesterday,” do not work. As financial economist John H. Cochrane has written, many empirical studies have shown that “trading rules, technical systems, market newsletters and so on have essentially no power beyond that of luck to forecast stock prices.” Indeed, Fama’s insight led to the development of index funds by investment management firms. Index funds do away with experts picking stocks in favor of a passive basket of the largest public companies’ stocks.
Fama’s insight also has implications for bubbles—that is, asset prices that are higher than justified by market fundamentals. As Fama said in a 2010 interview, “It’s easy to say prices went down, it must have been a bubble, after the fact. I think most bubbles are twenty-twenty hindsight. . . . People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong we ignore them.”
To determine how fully the asset market reflects available information in the real world, one must compare the expected return of an asset to the asset’s risk (both of which must be estimated). Fama called this the “joint hypothesis problem.” Testing the EMH in the real world is difficult since the researcher must stop the flow of information while allowing trading to continue.
Surprisingly, soccer betting allows a simplified form of the efficient markets hypothesis (EMH) to be tested in a way that bypasses the joint hypothesis problem. During a soccer halftime, however, play ceases, so no new information is provided. In an Economic Journal article, Karen Croxson and J. James Reade1 studied the reaction of soccer betting prices to goals scored moments before halftime. Croxson and Reade found that betting continued heavily throughout halftime, but the betting prices did not change—consistent with the EMH.
Fama does not claim that real-world financial markets are perfectly efficient. Under perfect efficiency, prices incorporate all information all the time. Fama studied the correlation between a stock’s long-term returns and its dividend-stock price ratio. If stock price changes did follow a truly “random walk,” there would be no correlation. This was not the case: there was a positive correlation between the dividend to stock price ratio and long-term expected returns.
Some financial economists, such as Shiller, do not believe that markets are efficient. But certainly markets are at least somewhat efficient. If markets were perfectly inefficient, a firm’s characteristics would have no influence or relation to its stock prices. This is unrealistic. A firm that is on the brink of going out of business could have a capital value higher than that of Apple or Exxon.
In the early 1990s, Fama and co-author Kenneth R. French developed a three-factor model of stock prices in response to the “anomaly” literature of the 1980s, which some economists saw as evidence against the EMH. The three-factor model introduces two new factors—company size and value—in addition to beta, as determinants of expected returns. Beta is a measure of risk from the well-known Capital Asset Pricing Model (CAPM). They found that, on the assumption that assets are priced efficiently, the evidence is consistent with the idea that “value stocks”—those whose share prices appear low relative to the book value of equity—and small-company stocks are riskier and, thus, earn higher returns. Their interpretation is subject to the above-mentioned joint hypothesis problem, however. Financial economists Josef Lakonishok, Andrei Shleifer, and Robert Vishny2 give evidence that value stocks are not riskier. They argue against the idea that assets are priced efficiently; their view is that the reason value strategies yield higher returns is that such strategies “exploit the suboptimal behavior of the typical investor.”
Fama strongly opposed the 2008 selective bailout of Wall Street firms, arguing that, without it, financial markets would have sorted themselves out within “a week or two.” He also argued that “if it becomes the accepted norm that the government steps in every time things go bad, we’ve got a terrible adverse selection problem.”
Eugene Fama earned his B.A. in Romance Languages from Tufts University in 1960. Shifting gears, he earned both an M.B.A. and a Ph.D. from the University of Chicago Graduate School of Business in 1963. He then joined the faculty of the University of Chicago Business School, which later became the Booth School of Business, where he is currently the Robert R. McCormick Distinguished Service Professor of Finance.
Croxson, Karen, and J. James Reade, “Information and Efficiency: Goal Arrival in Soccer Betting,” The Economic Journal, Vol. 124, Issue 575 (Mar. 2014), pp. 62-91.
Lakonishok, Josef, Andrei Shleifer, and Robert W. Vishny, “Contrarian Investment, Extrapolation, and Risk,” Journal of Finance, Vol. 49, No. 5 (December 1994), 1541-1578.