Invisible Hand

A Brief History of the Efficient Markets Hypothesis

Invisible Hand

In 2008, Nobel laureate Eugene Fama delivered a brief lecture to the American Finance Association. The entire 30-minute video is included below, and it is well worth an investment of your time. Fama was introduced by his son-in-law and colleague, John Cochrane, who explained that market efficiency means that asset prices incorporate available information about values, and prices change to reflect any unexpected new information. On its face, it is a very simple yet elegant idea that spawned massive empirical projects. Cochrane draws a close parallel between EMH and the theory of evolution, particularly with respect to the impact that each has had and continues to have on its field. As Cochrane remarked, “Without the efficient markets hypothesis, empirical finance would just be a collection of Wall Street anecdotes, how I got rich stories, and technical trading newssheets.”

Fama explained that the idea that prices adjust to new information implies that they move in a random walk. However, it is a specific type of random walk known as a martingale, or an unbiased random walk. Specifically, if at a given point in time, the S&P 500 Index is valued at 1,850, then the expected value in the next time interval is also 1,850 but adjusted for the expected return of the S&P 500 Index which is implicitly assumed to be constant. Looking at past price movements tells you nothing about future price movements. The market sets prices so that it is a fair game for investors—they get a positive expected return that compensates them for their exposure to risk.

The constancy of expected returns is the cornerstone of the Hebner Model, which states that prices change in response to changes in uncertainty, which is driven by the news. The Market Forces painting depicts the teeter-totter with prices on one side and uncertainty on the other, and expected return is at the fulcrum where it stays essentially constant, and the realized returns are seen on the Galton board below the teeter-totter where they fall into a bell-shaped curve.

Ever an example of true humility, Fama gives tremendous credit to his predecessors and his contemporaries such as Michael Jensen who pioneered the technique of performance evaluation (measuring additional return after accounting for risk exposure) that is still used today. In Fama’s words, “[Before Jensen’s thesis] all mutual funds were actively managed and they all claimed they beat whatever they wanted to beat and nobody ever stepped back and evaluated whether they actually did what they claimed to do.” Jensen showed that the level of observed alpha among all the mutual fund managers he studied was no higher than what would be expected from chance and thus consistent with an efficient market.

Another example of Fama’s humility is his designation of option-pricing theory as the most important development of the century (the last century) in finance. His reason for choosing that over EMH is that while everyone who studies or trades in derivatives is required to know about the Black-Scholes-Merton model, the same is not true for EMH, and Fama cites as proof the fact that less than 20% of mutual funds were passively managed as of 2008. Even before Fama was awarded the Nobel Prize in 2013, passive made significant strides against active in that five year period. We have been covering this long-term story in articles such as this one.

If you do not have the thirty minutes to watch the video below, then please consider watching Fama’s four minute Nobel Prize acceptance speech contained in this article. Either way, you will get an idea of what makes a true giant in the world of finance.