Devouring the News

Harry Markowitz Reflects on Eugene Fama's Nobel Prize

Devouring the News

After Scholes and Merton won the Nobel Prize in Economics for their and Fisher Black’s work on option pricing, whenever I was asked who among financial economists I thought would get the Prize next, Gene Fama topped my list of probable recipients.  Gene is especially noted for his work on the definition and measurement of market efficiency. 

Most recently his work with Ken French on their three-factor model is widely used; but it may be viewed as a continuation of Gene’s work on market efficiency. In particular, the Fama and French (1992) Journal of Finance article on “The Cross-Section of Expected Stock Returns” opens by noting that CAPM implies that (a) the market portfolio is a mean-variance (MV) efficient portfolio, and (b) there is a linear relationship between expected return and beta. Thus CAPM implies that expected return can be predicted by beta alone, and no other information can improve this prediction.  The Fama and French article then surveys the literature on market efficiency, which frequently fails to find CAPM’s linear relationship, as does their own work, and concludes therefore that the market portfolio must not be efficient.

Gene’s own earlier fundamental contribution to our understanding of efficiency appeared in his 1970 Journal of Finance article on “Efficient Capital Markets:  A Review of Theory and Empirical Work.” There he distinguished between the weak, semi-strong and strong forms of efficiency depending on what kind of information would be sufficient (if properly used) to “beat the market.” The weak form asserts that one cannot outperform the market using only stock prices; the semi-strong form asserts the same for any publicly available information; and the strong form asserts that even insider information is not sufficient to outperform the market.

My own 2005 Financial Analyst Journal article on “Market Efficiency: A Theoretical Distinction and So What?” distinguishes between the statement

          (1) Investors hold MV efficient portfolios, and the market is efficient in one of Fama’s senses: weak, semi-strong or strong

versus the statement

          (2) The market portfolio is MV efficient.

I show that Statement (1) implies Statement (2) only if one makes highly unrealistic assumptions concerning investor constraint sets, such as the Sharpe-Lintner assumption that investors can borrow at the risk-free rate without limit; whereas if borrowing is either forbidden or limited then typically the market portfolio is not MV efficient and there is not a linear relationship between expected returns and beta.

 My article illustrates why I was not surprised when Gene won the Nobel Prize.  When anyone, myself included, works in the area of market efficiency, we work with concepts that Fama laid down and subsequently built upon himself.