Fama’s MarketA Nobel for the economist who explained why stock prices are so hard to predict
In the late 1950s, Harry Ernst, a Tufts economics professor, was looking for ways to boost the stock market forecasting business he ran on the side. He turned to one of his promising undergraduates. “Can you design some models to beat the market?” Ernst asked Eugene Fama, a senior and student athlete who had only recently switched his academic interests from Romance languages to economics. Both men were puzzled when Fama’s models failed to work. Figuring out why would put Fama onto a research track that brought him to the Stockholm Concert Hall this past December to accept his share of the 2013 Nobel Memorial Prize in Economic Sciences.
Fama, A60, H02, is best known for his groundbreaking “efficient markets hypothesis,” which he developed a few years after leaving Tufts. The theory holds that the prices of stocks and other assets rapidly adjust to all available information, which makes markets pretty hard to beat and stock picking a futile exercise. Fama’s finding led to the creation of the hugely popular index fund industry as a low-cost, passive alternative to active investment managers, who, according to Fama, have about as much success at picking winners as random chance. Genial and happy to chat, Fama can be nonetheless blunt, referring, for example, to stories about what stocks to buy or to sell as “financial pornography.” Above all, Fama is a proud and determined empiricist; if the mantra of Tom Cruise’s character in the film Jerry Maguire is “Show me the money,” Fama’s is “Show me the data.”
Fama is not the first Nobelist from Tufts. Allan Cormack, a Tufts physics professor, won the prize in physiology or medicine in 1979 for research that led to the invention of CT scanning. And a medical school alumnus, Roderick MacKinnon, M82, H02, received the chemistry prize in 2003 for his work on understanding ion channels in cell membranes. A third Tufts figure, William Moomaw, a professor of environmental policy at the Fletcher School, sat on the United Nations climate change panel that shared the 2007 Nobel Peace Prize with Al Gore.
The latest laureate, who just turned seventy-five, has generated controversy over his half century at the cutting edge of financial economics. How he interprets the market has been widely challenged by economists and others who believe that markets are not so efficient or rational, and that human behavior, sometimes irrational, also influences prices. Perhaps tap dancing around this decades-long debate, the Nobel pickers spread out the 2013 economics prize to also include Robert Shiller, a leader in the field of behavioral finance at Yale University, and Lars Peter Hansen, an econometrician at Fama’s University of Chicago.
“The three-way award combination is brilliant,” says Daniel Richards, chair of Tufts’ economics department. “Fama shows why markets are efficient, Shiller shows why they are not, and Hansen provides econometric tools to show why both are right. I thought that Fama would be a candidate for the Nobel because of the sheer volume and breadth of his work,” as well as its originality.
Fama knows that his steadfast belief in the efficiency of markets seems out of sync to many people, especially non-economists, who see the Dow’s wild swings, and deep dives and sharp spikes in real estate and other asset prices, as manifestations of crowd psychology. “Frankly, people don’t want to think that markets work that well,” says Fama by phone from his winter home in California, days after his “incredible but totally exhausting” Nobel week in Sweden. “But the evidence looks pretty good that they are working well.” The whole concept of efficient markets “is generally misunderstood,” he adds. Just because markets are efficient, that does not mean they are perfect or easy to predict. “But that’s just something I’ve learned to live with for more than fifty years.”
In any case, Fama’s research into efficient markets is only a small part of his work, dating back to his graduate school days. “I soon moved on to other things,” he says. “Among finance people, my other work is much better known.” Indeed, he is often called the “father of modern finance” (a moniker he shares with other economists, including Paul Samuelson, Franco Modigliani, and Merton Miller), thanks to his influential body of research across many areas of finance and economics, including two books and more than a hundred papers. “But people fall asleep very quickly when you talk about things like models for risk and return, so they tend to emphasize the stuff that has gotten more general attention.”
The grandson of Sicilian immigrants, Fama was born in Somerville, Massachusetts, and grew up in Medford and Malden. He played basketball “poorly,” he says, but did well in football, track, and baseball at Malden Catholic High School, which placed him in its athletic hall of fame in 1992. John McGrath, his coach at Malden Catholic, remembers him fondly. “Gene was a very jovial, personable student athlete,” McGrath says. “He also got all A’s.” The Catholic brothers who ran the school asked McGrath to write Fama a letter of recommendation to Tufts, McGrath’s alma mater (he is class of 1954). “That was the first recommendation I ever wrote for any student,” McGrath says.
It worked. Fama became the first in his family to attend college when he arrived at Tufts in 1956, intending to become a high school teacher and coach. He majored in Romance languages, but by his junior year he became “bored with rehashing Voltaire.” He had also married his high school flame, Sallyann Dimeco, during his sophomore year, so Fama was looking for ways to support his family (which today numbers four children and ten grandchildren). That meant thoughts of a career in high school teaching and coaching “went out the window with Romance languages.” Though he had not even considered economics when he came to Tufts, just one class in his junior year—microeconomics with Professor Lewis Manly—left him “enthralled” with the subject.
By his senior year, Fama had begun to analyze stock market data when Ernst asked him to test his stock-picking methods. Fama was able to develop models that worked on a limited set of stocks, but they “invariably failed to work” when new data was introduced, Fama says. “Three years later, it dawned on me why.”
That dawning came at the University of Chicago, to which Fama’s Tufts professors had steered him even though most of their economics Ph.D.s were from Harvard. Fama earned an M.B.A. there and moved on to a Ph.D. His landmark dissertation took up an entire issue of the university’s Journal of Business when it was published in 1965.
Fama’s main thesis rings with a simplicity that masks the complicated analysis behind it: “An efficient market is a market that is efficient in processing information,” he wrote. “The prices of securities at any time are based on correct evaluation of all information available at that time.” In other words, since asset prices already reflect all relevant information, trying to beat the stock market—which is what Ernst wanted Fama to help him accomplish—is folly.
Subsequent research has challenged that basic hypothesis. Yale’s Shiller and other behavioral finance economists cite evidence that prices can be affected by human behavior, not just available information. Investment decisions aren’t necessarily data-driven, these behaviorists say; rather, psychological and other factors, such as something in the day’s news, can cause investors to act irrationally. Fama accepts research by Shiller and others who have documented deviations from expected market prices. But while Shiller attributes such deviations to behavioral factors (such as human irrationality), Fama attributes them to rational sources. “Shiller and I agree on the facts,” says Fama. “We disagree on the interpretation.” And until he sees solid data proving otherwise, Fama’s belief in the efficiency of markets stands.
So too does his willingness to speak his mind. “I’m pretty well known as an extreme libertarian,” he says. “I distrust politicians of all sorts. As an economist, I think they are all motivated by their own interests and only by power, which means spending money and directing things in a way that eventually chisels at freedom. Republicans and Democrats both like to spend—they just disagree on what they want to spend it on. Some people like to hear that, some people don’t.”
Fama’s work has ramifications well beyond the confines of academia. That huge index fund industry is one. More broadly, says Richards, Tufts’ economics chair, “Fama is the antidote to someone like Bernard Madoff. Madoff kept telling his investors that he was generating much better returns than the market because he was just brilliant, that he just kept getting the coin flips right. If people had read Fama at even the most basic level, they would know that people like Madoff will start throwing tails just like anyone else.”
Huntley Schaller, an economist at Carleton University in Ottawa, is familiar with all three 2013 economics Nobelists. Although he leans toward the behavioral school, the decades of challenge to Fama’s original efficient markets theory do not diminish the Chicagoan’s “enormous contributions,” Schaller says. He adds: “In the social sciences, coming up with predictions that turn out to be very close to being true is a huge contribution.”
Except for two years teaching in Belgium, Fama has been on the University of Chicago faculty since 1963. The “Chicago School” of economics is known for its belief in free markets, with minimal government intervention. Fama and Hansen increase to twelve the number of professors at what is now called the University of Chicago Booth School of Business who have won a Nobel in economics, a category that includes Milton Friedman.
A longtime friend, Joseph Neubauer, E63, describes Fama as “a wonderful guy and a perfect example of what Chicago produces.” The two shared Harry Ernst as both economics professor and mentor. Once, Ernst asked Neubauer what he planned to do after Tufts. Neubauer, who had only recently immigrated from Israel and was majoring in chemical engineering, replied that he planned to take a sales job with General Electric. But Ernst told him he should consider applying to business school, adding that he’d sent a student to Chicago who was doing pretty well. “I got into business school on the coattails of Gene Fama,” says Neubauer, who got his M.B.A. in 1965 at Booth, where he and Fama first met.
Neubauer sees Fama’s journey as uniquely American. “Gene is a very humble kid from the neighborhood. He goes to a world-class university and then from majoring in Romance languages to helping revolutionize the science of economics and finance.” Neubauer goes on to say: “Gene is a great example for graduates from Tufts that where you start is not necessarily where you have to end up.” Neubauer himself went on to become CEO and then chairman of Aramark Holdings Corporation and its subsidiary, Aramark Corporation, which provides food and other services for businesses. A former Tufts trustee, he was instrumental in the honorary degree Fama received in 2002.
By then, Fama’s name was in the Nobel prize rumor mill. “They started to mention my name twenty years ago, maybe more. But after a while, the probability is so low that you will get one at any time that you don’t really expect it.” So Fama was surprised when the phone rang with the Nobel news last October 14 while he was doing back exercises to prepare for class. He was also surprised by one of his first congratulatory emails. It came from Sylvan Barnett, a Tufts professor emeritus of English.
“He didn’t think I’d remember him, but I most vividly do,” says Fama. “I took an English course with him and he gave me the only B I got at Tufts. He tore my papers to smithereens, and properly so. Economics is one skill, but about fifty percent of the success of doing research is being able to convey it to other people in the simplest possible terms. That was the message I got from that course—be precise, be concise, and be clear.”
Fama was overwhelmed by his Nobel experience. “You’re happy to be there, but you’re happy to get it over with,” he says. “I was sleep-deprived for two months. My whole family came to Sweden, and they had a great time. But I had to spend every minute doing interviews, TV tapings, and all that stuff. And you have to be on your best behavior at all times, which is not my style. Chicago is a rough-and-tumble place where everyone treats each other respectfully, but they don’t pull any punches either. I’m also not someone who likes adoration. I don’t trust it.”
Fama is ready to return to Chicago and to teaching this spring. “I’m going back to my old simple life”—which includes being a director and consultant to Dimensional Fund Advisors Inc., a money management firm whose investment products are based in large part on Fama’s concepts. The former high school sports star also remains physically active: he likes to windsurf and golf, though his tennis game “is fading.”
He planned to make this Tufts Magazine interview one of his last for a while. Until the Nobel was announced, he says, “reporters weren’t interested in me. Now they all are. But I’m still the same old dumb guy I was before the Nobel. I work hard, play hard, and have a great family life. I don’t know what more I could have than that.”
Phil Primack, A70, is a freelance editor and writer in Medford, Massachusetts.