Eugene Fama Photo

Eugene Fama Wins the 2013 Nobel Prize in Economics

Eugene Fama Photo

At Index Fund Advisors, we were absolutely thrilled to hear the announcement by the Royal Swedish Academy of Sciences that the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2013 is being awarded to Eugene F. Fama (University of Chicago), Lars Peter Hansen (University of Chicago), and Robert J. Shiller (Yale University) “for their empirical analysis of asset prices”. Regarding Fama’s portion of the prize, the Nobel committee stated this in its press release:

“Beginning in the 1960s, Eugene Fama and several collaborators demonstrated that stock prices are extremely difficult to predict in the short run, and that new information is very quickly incorporated into prices. These findings not only had a profound impact on subsequent research but also changed market practice. The emergence of so-called index funds in stock markets all over the world is a prominent example.”

Professor Fama is widely recognized as the “father of modern finance.” To say that we at Index Fund Advisors are delighted by today’s announcement would truly be an understatement. From its inception in 1999, Index Fund Advisors has consistently been espousing the benefits of investing in accordance with Fama’s conclusions (i.e., index funds). We have always thought that Eugene Fama was deserving of a Nobel Prize. Our only question was whether Ken French would be accorded the honor as well. We note that in the scientific explanation of this year’s prize, eleven of Ken French’s articles are cited, so if there had been a fourth winner, we have no doubt it would have been him.

A Phone Call from Adam Smith

We could not help but notice the coincidence that the name of the person from nobelprize.org who called to officially congratulate Fama is named Adam Smith. You may recall that name from his 1776 landmark book, The Wealth of Nations, in which he asserted that free market countries were positioned to prosper. Guided by “the invisible hand”, individuals acting in their own self-interest would benefit society as a whole. Fama’s work relates to how the invisible hand of the market prices financial assets so that investors can expect a return to compensate them for the risk they take.

Naturally, Fama said he was “Thrilled” to hear the news, and when asked if he ever thought how he might react to this news, if it came, Fama responded, “I don’t know…I didn’t want to ever presume that I would win.”

When asked about the incredible record of the University of Chicago in winning Nobel Prizes (28 of 74 winners, or 38%, either taught at or attended the University of Chicago), Fama gave a response that reflects true humility:

“Well, we have good people – you need that, obviously. And it's a very interactive environment; people help one another out a lot. I mean, I couldn't do what I did without the help of my professors at the time and colleagues since then and students since then. It's a very interactive place, where everybody contributes to everybody else.”

One interesting point that emerged from the interview was that economics was not Fama’s original choice of college major. It was actually French, but as Fama put it, “I was getting kind of tired of French, and so I took an economics course an economics course and I loved it, and the rest of my two years in college I spent in economics.” One of Fama’s professors was Merton Miller, one of the winners of the 1990 Nobel Prize in Economics along with Harry Markowitz and Bill Sharpe.

At the end of the interview, Smith asked Fama to summarize the relevance of his work to the world at large. Fama responded, “The idea is really ‘how do you measure risk?” And if the market is pricing things correctly, what is the relationship between the expected return, which is the compensation for risk, and the risk?”

As we have always said at Index Fund Advisors, risk and return are not just related, they are joined at the hip. Investors would do well to never forget that.

A Very Impressive Academic Family Tree

According to his page on the University of Chicago Booth School of Business Website, Fama has authored (or co-authored) 105 articles and two books that are considered classics in the field of finance. One of these books, The Theory of Finance, was co-authored with Merton Miller. The Nobel Prize is merely the latest of honors received that are too numerous to catalog here. Fama is the Chairman of the Board of the Center for Research in Security Prices, and he is a Board Member of Dimensional Fund Advisors (DFA) where he has been instrumental in the formulation of investment policy that has led to DFA’s phenomenal growth to having $287 billion of assets under management as of 6/30/2013.

In the world of academia, a professor’s students are sometimes deemed to be his or her children, and their students would be his or her grandchildren, etc. If we were to attempt to draw up Fama’s academic family tree, we would need an inconceivably large piece of paper. Just to name a few of his students:

1)      David Booth—One of the co-founders of DFA for whom the Booth School of Business at the University of Chicago is named.

2)      Rex Sinquefield—The other co-founder of DFA and one of the co-authors of Stocks, Bonds, Bills, and Inflation.

3)      Roger Ibbotson—The other co-author of Stocks, Bonds, Bills, and Inflation and founder of Ibbotson Associates that was purchased by Morningstar, Inc. He is a colleague of Robert Shiller’s at Yale University.

4)      Brad Barber—A professor of Finance at UC Davis where he has co-authored important papers regarding the sub-optimal trading behavior of individual investors.

Nobody can deny that Professor Fama has created a legacy that will endure for a very long time to come. Without equivocation, we can say that we at Index Fund Advisors would not be here today without the contributions of Eugene Fama. In that way, we consider ourselves to be his academic descendants as well.