Because of our strategic relationship with Dimensional Fund Advisors (DFA), you may have recognized the name of Eugene Fama, a Director and Consultant of DFA, in the news. Dr. Fama, along with Robert Shiller and Lars Peter Hansen, recently received the 2013 Nobel Prize for Economics. Interestingly, awarding the Nobel Prize to these three economists has created quite a bit of buzz. In fact, the term “barbell” has been used to describe the awards because the American economists hold contradictory views on the complexities of asset pricing.
Let me explain. On one end of the barbell, University of Chicago’s Eugene Fama, the “Father of Modern Finance” believes that because stock prices reflect all available information, our markets are efficient. On the opposite side, Robert Shiller of Yale believes that over the long-term stock and bond markets reach prices at odds with economic fundamentals due to investors’ irrationality. And, in the middle of these opposing camps, Lars Peter Hansen of the University of Chicago has developed statistical models that can be employed to test various theories regarding the price movements of assets.
Noting that, over the span of 50 years, the three economists’ research has “laid the foundation for the current understanding of asset prices,” the Royal Swedish Academy of Sciences hinted that it understood the irony of naming both Fama and Shiller as winners. For instance, the press release described the prize-winning economics research as relying “in part on fluctuations in risk and risk attitudes, and in part on behavioral biases and market frictions.”
Academics have weighed in on Fama and Shiller’s dueling philosophies, too. For example, Robert Solow, the winner of the Nobel Prize for economics in 1987 and professor emeritus at the Massachusetts Institute of Technology, acknowledged that the winners represent a “very interesting collection because Fama is the founder of the efficient-market theory and Shiller is one of the critics of it.” He went on to say that awarding both the prize in the same year is like “giving a prize to the Yankees and the Red Sox,” thereby suggesting that much like the huge baseball rivalry between New York and Boston, “there really isn’t a settled doctrine in finance.”
MIT professor of economics Andre Lo summarized the seemingly contradictory awards this way: “Financial markets can be efficient most of the time but every once in a while they break down and then we need to develop better analytics to be able to understand them. The choice of having Hansen complement the two extremes of efficient markets and inefficient markets is the perfect balance between the two.”
In another article, David Backus, an economist at New York University, surfaced the notion that Fama’s research has often been misunderstood. In short, he notes that Fama’s “efficient markets” do not always mean effective market operation. For example, while Fama’s critics point to the financial crisis and recession as proof that financial markets are not efficient, Backus insists on a more narrow reading of Fama’s theories. “Fama said that information out there will be reflected in (asset) prices,” Backus commented. “That is completely different from saying financial markets work well.”
In thinking about the awarding of the Nobel Prize, I’m reminded of a quote from Eugene Fama: “The true value of academic research isn’t that really smart guys who understand things better than we ever will come up with it–the true value is that it identifies what we need to focus on to succeed, and helps us to understand it.”
In other words, Fama wants his theories to simplify investing and add value for everyone. Accordingly, there’s a simple takeaway from his “efficient market hypothesis,” defined by the MIT Dictionary of Modern Economics as “The view that the prices of shares on the stock market are the best available estimates of their real value because of the highly efficient pricing mechanism in the stock market.” That is, contrary to what many personal finance magazine articles want you to believe, attempting to “beat the market” is futile.
In short, Fama’s efficient markets theory underscores the effectiveness of “passive management” which seeks to mirror market returns over “active management” that seeks to add excess returns. His research also supports the view that mutual funds with a number of diverse stocks are less risky than owning individual stocks. Additionally, a buy and hold philosophy is more effective over the long term than trying to time the market.
In fact, Fama’s market efficiency theory forms the foundation of the mutual fund company founded by two of his graduate students. Dimensional Fund Advisors is now one of the largest mutual fund families with over $300 billion under management. In addition to serving on DFA’s board of directors, Fama contributes to the firm’s research efforts.
In announcing Fama’s award, DFA praised his groundbreaking work on asset pricing and his ongoing contributions that have guided the firm’s investment approach for more than three decades. DFA’s website reads, “We extend our congratulations to Gene for this well-deserved recognition and thank him for his profound impact on Dimensional and investors worldwide.” I couldn’t agree more.
For more information, visit DFA’s website where you can watch Professor Fama discuss the evolution of finance and DFA’s Chairman and Co-chief Financial Officer David Booth reflect on Eugene Fama’s historic career.