“In an efficient market, at any point in time, the actual price of a security will be a good estimate of its intrinsic value.” – Eugene Fama
On October 14, Eugene Fama was one of three U.S. economists recognized by theRoyal Swedish Academy of Sciences and awarded the 2013 Nobel Memorial Prize in Economic Sciences for work in the area of “trendspotting in asset markets.” Fittingly, Fama is recognized worldwide as the leader of the empiricism that proved the fundamental truth that markets work, at least in the financial markets.
This idea was first conceived by Adam Smith and published in the groundbreaking 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, which outlines topics that were critical to the new dawn of the Industrial Age, such as productivity, labor and free markets. Next , the 20th century benefited from the wisdom and insight of Friedrich Hayek, who took Smith’s ideas a step further with his work on economic fluctuations, money theory and the influential concept that prices are a reflection of all of the available information.
But, it was Fama’s empirical studies that led to his development of the efficient-market hypothesis (EMH), which illustrates, unequivocally, that the price of an asset is an accurate reflection of all available information. Fama now is known as the father of efficient markets and his vast body of work is influencing public policy around the world.
Fama’s seminal work in the area of efficient markets was published during the time when I was one of his budding graduate school students at the University of Chicago. The Efficient Capital Markets: A Review of Theory and Empirical Work, which appeared in the Journal of Finance in 1970, introduced the EMH concept that led to the creation of the index fund, now the world’s most popular form of investment. This same theory informs not only private and institutional investment decisions throughout the world, but also is used to determine economic policy and financial regulations.
Tuesday’s Wall Street Journal Op-ed, Nobels and National Greatness, declared that “A culture of individualism and an ingrained respect for against-the-grain thinking,” is essential to America’s position as home to the greatest number of Nobel Prize winners.
Clearly, Eugene Fama is a true American icon. The influence of his research and against-the-grain thinking is far-reaching. For investment purposes, the implication of the EMH is that the best strategy is to avoid the temptation to stock pick. Accept the market returns that exist, they are high and they are for the taking. The implication for policymakers is similar. Government should not be in the business of picking winners and losers and using taxpayer dollars to back their bets. If markets work, then markets work. It is just that simple. If seasoned investors can’t outguess markets, then government officials should not try to do so either.