When As Good As It Gets Isn't Good Enough


One of the accusations constantly levied against 2013 Nobel Laureate Eugene Fama is that he uses his Efficient Market Hypothesis as a justification to denigrate all forms of financial regulation, including regulations governing trading by company insiders. A good example of such an accusation can be found in this column in the Washington Post where the author presumes that Fama regards insider trading rules as superfluous because, “even nonpublic information known to insiders is reflected magically in stock prices!”

There are two things wrong with this accusation. First, Fama proposed EMH purely as a model and not a statement of fact, as is implied in “hypothesis”. He outlined three different possibilities for the degree to which markets may be efficient, and two of these three do not require that prices incorporate insider information.

1)      The Weak Form – Market prices incorporate all price history data, rendering technical analysis useless.

2)      The Semi-Strong Form – Market prices incorporate all publicly available information, rendering fundamental analysis an exercise in futility.

3)      The Strong Form – Market prices incorporate all available information, meaning that even insiders cannot earn abnormal profits from trading their company’s stock.

As discussed in the interview below, Fama is very clear that the market should not be considered efficient for company insiders who trade their company’s stock. However, Fama quantifies the additional expected return for these insiders at a paltry 1%. Considering the concentration risk and the doubling down on exposure to the fortunes of one company, this is definitely not a risk worth taking.


Of course, Fama was referring to legal insider trading, on which we have extensive public records. One article1 that we found from 1988 quantified the insider benefit at 3%, again nothing to write home about. As for outsiders placing trades based on public information about insider trades, the expected benefit was found to be exactly zero—right in line with the semi-strong form of market efficiency.

The second problem with that accusation is that Fama has never advocated for the legalization of insider trading. On DFA’s Fama/French forum, Fama and French jointly stated that legalization of insider trading would create a big moral hazard problem in encouraging company managers to destroy value and profit from it by short-selling. However, even if only insider buying were allowed, it would violate the principle that a firm’s managers are supposed to act in the interests of shareholders because a manager who buys stock based on positive inside information is disadvantaging the seller—an existing shareholder. They also debunk the myth that allowing insider trading would increase the flow of information to the market, as it would simply incentivize managers to delay disclosure of insider information.

IFA has always encouraged its clients to diversify their investments as much as possible. This can sometimes mean limiting one’s holding of his company’s stock. Even in situations where trading one’s company’s stock is legal, IFA discourages it. We often describe the returns offered by the market with the phrase, “as good as it gets”. For those insiders who feel compelled to try to legally profit from their edge on the rest of the market, we wish them the best but warn them to expect disappointment. As for those insiders who attempt to illegally profit from material nonpublic information, they should give careful consideration to how they would look in an orange jumpsuit. Lastly, regarding the pundits who have been hurling unfounded accusations at Eugene Fama, even blaming him for the 2008 financial crisis, we will quote Jack Nicholson: “Sell crazy someplace else! We’re all stocked up here.”


1Rozeff, Michael S. and Zaman, Mir A., Market Efficiency and Insider Trading: New Evidence. Journal of Business, January, pp. 25-44, 1988. Available at SSRN: