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Eugene Fama: A New Way to Look at the Stock Market
Applications / Applied Data Science

Eugene Fama: A New Way to Look at the Stock Market

4 min read
06_03_2021
The Nobel Prize-winning economist is described by the New York Times as a “congenial, open conversationalist,” but Eugene Fama has been the source of significant controversy in the roughly 50 years he’s been writing about the stock market.

While many economists believe that the stock market is heavily influenced by irrational human impulses, and therefore is prone to “bubbles,” Fama’s efficient market hypothesis holds that stock prices are a rational reflection of publicly-available information. This revolutionary concept, along with some of Fama’s other economic models, have had a major influence on how Wall Street traders analyze financial data and make investment decisions.

Ditching French for finance

Fama, who was born in 1939, was raised in a working-class family outside of Boston and entered Tufts University with plans to study Romance languages and become a school teacher. Eventually, however, he grew “bored of rehashing Voltaire” and decided he wanted to make more money than what he’d earn on a teacher’s salary.

He switched to economics, earning a bachelor’s degree at Tufts and then a PhD at the University of Chicago, where he studied under acclaimed figures of the “Chicago School of Economics,” a group of economists who tended to favor a laissez-faire approach to economic policy.

“The question is when is active (portfolio) management good? The answer is never.”

Modeling the Market

As a student and later as a professor, Fama attracted attention for his observations on the behavior of stocks. In a 1965 paper explaining the theory of “random walks,” Fama cast doubt on the ability of investment experts to produce better returns for their clients than a portfolio of randomly-selected stocks. The evidence, he said, showed that short-term fluctuations in stock prices were practically impossible to predict.

“I’d compare stock pickers to astrologers but I don’t want to bad mouth astrologers.”

However, over the years Fama identified trends that he believed could help you beat the market in the long-term. In 1992, he and fellow economist Kenneth French developed the Fama-French three-factor model, which proposed three factors that predict stock returns:

  • The Size of the Firm
  • The firm’s book-to-market value (the total value of its assets compared to its total value on the stock market)
  • The amount by which the stock outperformed a “risk-free” asset, such as a U.S. government bond

Fama and French later updated their model to include two other factors: profitability and how aggressively a firm invests its profits.

A Voice for Restraint

Investment professionals have adopted Fama’s insights and incorporated them into algorithms they use to try to gain an edge in the market. However, perhaps the greatest impact of Fama’s data analysis has been to caution investors, particularly regular people trying to save for their retirement, against trying to place big bets. Especially in a world where information moves at lightning speed, it’s very unlikely that you know something that everyone else doesn’t already know.

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