1965 - Efficient Markets

Eugene Fama

In recognition of his contributions to asset pricing theory, Eugene Fama was awarded the Nobel Prize in Economic Sciences in 2013. Fama is a University of Chicago professor of finance, and is widely viewed as the "Father of Modern Finance." Fama set out to explain why stock market prices fluctuate randomly, and his findings led to his coining of the phrase "Efficient Market." In "The Behavior of Stock Market Prices,"1 published in 1965, Fama examined the prevailing assumption that the tremendous resources available to any major brokerage firm, including industry trends, effects of interest rates, accounting data, and access to managers of firms consistently allowed fund managers and security analysts to outperform a randomly selected portfolio of securities with similar general risk levels. However, the study determined no such advantage existed beyond that attributed to chance alone. In 1970, Fama published his Efficient Market Hypothesis in "Efficient Capital Markets: A Review of Theory and Empirical Work,"2 in which he concluded equity markets consistently incorporate all available information into their prices, and trends in capital markets cannot be identified in advance. He found that an agreement between a buyer and a seller reflects the most accurate value of a security, resulting in an environment where the only way an investor can expect to beat the market return is by taking risk greater than the market. This can be accomplished by increasing exposure to small cap and/or value stocks.

Kenneth French

Eugene Fama and Kenneth French's 1992 paper, "The Cross-Section of Expected Stock Returns,"3 expanded upon the Nobel Prize-winning research of Harry Markowitz and William Sharpe that delivered Modern Portfolio Theory. Fama and French determined that exposure to market, size and value risk factors explained as much as 96% of historical returns in diversified stock portfolios. Their discoveries serve as the foundation for constructing indexes that efficiently capture risks and returns based on five independent risk factors, including term and default for fixed income.

    -1 Eugene F. Fama, "The Behavior of Stock Market Prices," The Journal of Business, vol. 38, no. 1. (1965): 34-105.
    -2 Eugene F. Fama, "Efficient Capital Markets: A Review of Theory and Empirical Work," The Journal of Finance, vol. 25, no. 2 (1970).
    -3 Eugene F. Fama and Kenneth R. French, "The Cross-Section of Expected Stock Returns," The Journal of Finance, vol. 47, no. 2 (1992).
Step 2Eugene FamaKenneth FrenchModern Portfolio TheoryHarry MarkowitzWilliam Sharpe