Congratulations to Eugene Fama, the father of the “Efficient Markets Theory,” for winning the Nobel Prize in Economic Sciences. Fama shared the prize with Robert J. Shiller and Lars Peter Hansen.
In the 1960s, Fama, a University of Chicago financial professor, found that it was nearly impossible to predict short-term changes in stocks prices. The market was extremely efficient at taking new information and integrating that news into a stock price, so trying to outguess the market was a fool’s game.
Fama, along with long-time collaborator Kenneth French of Dartmouth University, later gain even more fame by creating a model of that explained well over 90% of a stock portfolio’s long-term returns based on the types of stocks of the portfolio held.
These combined works demolished the idea that the vast majority of stock mutual fund managers added any value. Sure, a few of them will get lucky, but your odds of picking the one lucky manager are about one in a hundred at best. For the rest, you’re simply paying a lot of money for someone to give you average returns. (How much money? On average, the fees that you pay for a stock mutual fund manager will lower your final portfolio by around 33% if you’re investing over 20 years.)
My investment strategy has always been based on academic research and data rather hunches or hope. French and Fama’s work over the past 50 years has been an integral part of that analysis. That Wall Street – and, sadly, most investors – continue to ignore the overwhelming evidence that it’s nearly impossible to beat the market is a testament to the power of marketing.
Besides providing me with a general strategy, French and Fama’s work – along with many others – also has given me the tools to execute that strategy. The mutual fund company Dimensional Fund Advisors (DFA) was founded by students of French and Fama. After learning that diversifying among different parts of the stock market was the key to higher returns, those students discovered that no mutual fund company applied that research in their funds. Sensing a void, the students did what entrepreneurs do: They saw a need and filled it, creating mutual funds that allowed investors to cheaply capture various parts of the stock market and thus create truly diversified portfolios.
In the decades since, other mutual fund companies have follow DFA’s lead; however, DFA remains at the forefront of both providing mutual funds based on the latest academic research and generating their own analysis of how markets work through their own fieldwork. (DFA is more like a think tank with a mutual fund company attached to it.) As a result, I continue to heavily employ DFA mutual funds to help my clients achieve their best risk-adjusted returns.
Both I and my clients owe a debt to Fama for helping us understand how stock markets work and how to best reach our financial goals in life.
Mark on Money 