David R. Henderson  

Bio of Eugene Fama

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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."


This is from "Eugene Fama," which has recently been added to The Concise Encyclopedia of Economics. It is a propos, given the recent discussion of stock prices on Econlog (here and here.)


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COMMENTS (4 to date)
AlexR writes:

Great entries on the Nobel Laureates, David!

p.s. I think the qualifier "that is publicly available" is unnecessarily restrictive. As you go on to explain, even private information tends to be revealed in the stock price through the privately informed trader's market trades.

Steve Y. writes:

Every finance course I took in the mid-1970's required us to read "The Adjustment of Stock Prices to New Information" by Fama, Fisher, Jensen, and Roll.

I sometimes wonder whether the order of the names in the seminal 1969 paper reflected the authors' respective contributions, or whether, reflecting the ethos of those self-effacing times, the names were simply presented in alphabetical order.

Eugene Fama's honors are deserved, but it couldn't hurt to have thousands of citations for Fama et al.

Barry Cotter writes:

Index funds precede Fama's first publications on market efficiency. From wikipedia

"John Bogle graduated from Princeton University in 1951, where his senior thesis was titled: "Mutual Funds can make no claims to superiority over the Market Averages." Bogle wrote that his inspiration for starting an index fund came from three sources, all of which confirmed his 1951 research: Paul Samuelson's 1974 paper, "Challenge to Judgment", Charles Ellis' 1975 study, "The Loser's Game", and Al Ehrbar's 1975 Fortune magazine article on indexing. Bogle founded The Vanguard Group in 1974; it is now the largest mutual fund company in the United States as of 2009.

Bogle started the First Index Investment Trust on December 31, 1975. At the time, it was heavily derided by competitors as being "un-American" and the fund itself was seen as "Bogle's folly"

"Economist Eugene Fama said, "I take the market efficiency hypothesis to be the simple statement that security prices fully reflect all available information." A precondition for this strong version of the hypothesis is that information and trading costs, the costs of getting prices to reflect information, are always 0 (Grossman and Stiglitz (1980))." A weaker and economically more sensible version of the efficiency hypothesis says that prices reflect information to the point where the marginal benefits of acting on information (the profits to be made) do not exceed marginal costs (Jensen (1978)). "

David R. Henderson writes:

@Barry Cotter,
Thank you. You are right on this. John Bogle himself corrected me after I made the same mistaken attribution in my Wall Street Journal op/ed the day after Fama won the prize. In my haste, I missed that. I will make the appropriate change in the bio.
First, though, I want to check the Al Ehrbar article in Fortune in 1975. I met Al at Mike Jensen’s place a few months after that article appeared. Al was a recent graduate of the University of Rochester’s Executive MBA program and was up in Rochester visiting. I had just arrived in August 1975 as an assistant professor in the Graduate School of Management (now the Simon School.)
I know that Al was influenced strongly by Jensen’s and Fama’s work. So maybe Fama had indirect influence on Bogle through Ehrbar. I do recall, though, Al complaining that Fama would never return his phone calls and Mike Jensen telling him that Fama would never return any reporter’s phone calls. :-)

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