As we crafted our post, “Nobel Honors an Honorable Man,” I found myself torn. And, as someone who savors life’s side shows as much as the main events, there were a couple of themes I wanted to explore related to Fama’s receipt of his Nobel prize. But unfortunately, I felt they detracted from the central point about how Fama and friends’ insights have significantly contributed to our evidence-based investment strategy.
Still, they’re considerations I thought you’d enjoy. So here they are in a bonus post of “deleted scenes.” Enjoy!
One of the great ironies of Dr. Fama’s award is that he is sharing it with Professor Robert Shiller, a proponent of the theory that markets are not always driven by the calculations of “rational” economic actors but frequently by emotion; leading to large swings in prices untethered to actual values.
For many on the inside of financial economic drama, the shared award comes with some bemusement, in that Dr. Shiller is often found at loggerheads with Dr. Fama regarding the role that market efficiency plays in investors’ decisions. In a Bloomberg column, 1987 Nobel laureate Robert Solow said that naming professors Fama and Shiller as co-recipients is “like giving a prize to the Yankees and the Red Sox.” (Fama, of course, is a Boston native. I’ll always wonder whether he is more pleased with his Nobel Prize or with the Red Sox three recent World series crowns.)
As in any academic field, financial economists forever wrangle over points that may seem agonizingly granular to most of us, but that can still have significant impact on our daily lives – for good or for ill. In this case, the debate is approximately over whether overall market efficiency should lead us to patiently participate in the market throughout its volatile swings, or whether potentially predictable irrational investor behavior (bubbles) may justify trying to respond to shorter-term fluctuations.
In light of the collective evidence available from professors Fama, Shiller and others whose work we routinely track, we remain convinced that your best financial interests are served – and your carefully planned goals most likely achieved – by avoiding the expenses involved in trying to profit from market irrationality. The practical hurdles continue to strike us as counterproductive in a long-term planning process.
One of the more beguiling aspects of Fama’s work is its co-opting by believers in laissez-faire economics. Strongly influenced by Milton Friedman and the so-called “Chicago School,” these economists and their acolytes are unrelenting in favoring unregulated, free-market solutions to economic problems.
Among the more powerful and well-known is former Federal Reserve Chairman, Alan Greenspan who, until recently, believed these principles meant that most markets were “self-regulating.”
Recent history has amply indicated otherwise. What Fama postulated as the Efficient Market Hypothesis (EMH) – and then demonstrated empirically – is that public stock prices are very efficient; they are determined by a market with voluminous information floating around. EMH has profound implications for investors in public securities markets.
But at least developed economy stock markets are highly regulated, especially with regard to ensuring a fair flow of information to all investors. In the United States, we have the Securities Acts of 1933, 1934 and 1940; rules forbidding insider trading; and, most recently, SEC Regulation FD mandating that all publicly traded companies disclose material information to all investors at the same time.
But if you move outside this realm of developed capital markets, I believe there’s a big world out there where the language of EMH may not compute. Differences between these and our public securities markets impact how we should view our related public policies.
In other words, Fama’s theories simply do not cross all the way over into markets that are characterized by informational opaqueness. Take health care, for example. I can’t figure out what some recent health care services cost even after I have received the bills and the explanation of benefits. Toxic products that led to the 2008 financial crisis, such as packages of subprime assets rated AAA by ratings agencies, were impenetrable even by some of the most sophisticated investors.
Fama, himself, is more equivocal on the subject of regulation and government intervention. In this New York Times interview, he says he’s a libertarian, but he also favors a social safety net and government intervention to prevent economic calamities.
Maybe the real reason Professor Gene Fama is a hero to me is because, in the words of F. Scott Fitzgerald, “The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function.”