Eugene Fama

Graduate studies, career, and research

Fama's MBA and PhD came from the University of Chicago Booth School of Business in economics and finance. His doctoral supervisors were Nobel prize winner Merton Miller and Harry V. Roberts, but Benoit Mandelbrot was also an important influence. He has spent the entirety of his teaching career at the University of Chicago.

His PhD thesis concluded that short-term price movements of publicly listed shares are unpredictable and approximate a random walk. This work was published in the January 1965 issue of the Journal of Business, entitled "The Behavior of Stock Market Prices". Later work with Kenneth French showed that predictability in expected stock returns can be explained by time-varying discount rates. For example, higher average returns during recessions can be explained by a systematic increase in risk aversion, which lowers prices and increases average returns. His 1969 article "The Adjustment of Stock Prices to New Information" in the International Economic Review was the first significant event study. This study sought to analyze how stock prices respond to an event using price data from the newly available CRSP database. This was the first of literally hundreds of such published studies.

Fama has served on the Board of Directors of money management firm Dimensional Fund Advisors since 1982. As of the end of 2024, DFA had $786 billion of assets under management. In 2013, Fama was awarded the Nobel Memorial Prize in Economic Sciences. In 2019, the University of Chicago announced that a student house at Woodlawn Residential Commons would be named after Fama.

Efficient market hypothesis

Fama is most often thought of as the father of the efficient-market hypothesis, which began with his PhD thesis. In 1965 he published an analysis showing that stock prices exhibit fat tail distribution properties, implying extreme movements were more common than predicted on the assumption of normality.

In an article in the May 1970 issue of the Journal of Finance, entitled "Efficient Capital Markets: A Review of Theory and Empirical Work", Fama proposed two concepts that have been used on efficient markets ever since. First, Fama proposed three types of efficiency: (i) strong-form; (ii) semi-strong form; and (iii) weak efficiency. They are explained in the context of what information sets are factored in price trend. In weak form efficiency the information set is just historical prices, which can be predicted from historical price trend; thus, it is impossible to profit from it. Semi-strong form requires that all public information is reflected in prices already, such as companies' announcements or annual earnings figures. Finally, the strong-form concerns all information sets, including private information, being incorporated in price trend; it states no monopolistic information can entail profits, meaning insider trading cannot make a profit in the strong-form market efficiency world.

Second, Fama demonstrated that the notion of market efficiency could not be rejected without an accompanying rejection of the model of market equilibrium. This concept, known as the "joint hypothesis problem", has ever since vexed researchers. Market efficiency denotes how information is factored in price, and Fama (1970) emphasizes that the hypothesis of market efficiency must be tested in the context of expected returns. The joint hypothesis problem states that when a model yields a predicted return significantly different from the actual return, one can never be certain if there exists an imperfection in the model or if the market is inefficient. Researchers can only modify their models by adding different factors to eliminate any anomalies, in hopes of fully explaining the return within the model. The anomaly, also known as alpha in the modeling test, functions as a signal to the model maker whether it can perfectly predict returns by the factors in the model. However, as long as there exists an alpha, neither the conclusion of a flawed model nor market inefficiency can be drawn according to the Joint Hypothesis. Fama (1991) also stresses that market efficiency per se is not testable and can only be tested jointly with some model of equilibrium, i.e. an asset-pricing model.

Fama–French factor models

In recent decades, Fama has continued to write influential papers, often co-written with Kenneth French, that challenge the validity of the CAPM, which posits that a stock's beta (${\displaystyle \beta }$) alone should explain its average return. These papers describe two factors in addition to a stock's market beta which can explain differences in stock returns: market capitalization and relative price. They offer evidence that a variety of patterns in average returns, often labeled as "anomalies" in past work, can be explained with their three-factor model. The three-factor model used returns on the market, value (measured using book value of equity-to-market value of equity), and size (market cap) to explain portfolio returns. The model introduced in this 1993 article rapidly became a standard benchmark in academic papers for evaluating portfolio performance.

The initial Three-Factor model is expressed as:

${\displaystyle R_{it}-R_{ft}={\alpha }_{it}+{\beta }_i(R_{Mt}-R_{ft})+s_i{\mathit{S}\mathit{M}\mathit{B}}_t+h_i{\mathit{H}\mathit{M}\mathit{L}}_t+{ϵ}_{it}}$

In this equation, ${\displaystyle \mathit{S}\mathit{M}\mathit{B}}$ (Small Minus Big) accounts for the size premium and ${\displaystyle \mathit{H}\mathit{M}\mathit{L}}$ (High Minus Low) accounts for the value premium.

In 2015, Fama and French expanded this framework to include profitability and investment factors to create a five-factor model. They argued that the three-factor model was incomplete because it ignored much of the variation in average returns related to profitability and investment. The Five-Factor model is defined as:

${\displaystyle R_{it}-R_{ft}=a_i+{\beta }_i(R_{Mt}-R_{ft})+s_i{\mathit{S}\mathit{M}\mathit{B}}_t+h_i{\mathit{H}\mathit{M}\mathit{L}}_t+r_i{\mathit{R}\mathit{M}\mathit{W}}_t+c_i{\mathit{C}\mathit{M}\mathit{A}}_t+e_{it}}$

In this model, ${\displaystyle \mathit{R}\mathit{M}\mathit{W}}$ (Robust Minus Weak) represents the difference between the returns of firms with high and low operating profitability, while ${\displaystyle \mathit{C}\mathit{M}\mathit{A}}$ (Conservative Minus Aggressive) represents the difference between the returns of firms that invest conservatively versus aggressively. Their research showed that with the addition of these factors, the ${\displaystyle \mathit{H}\mathit{M}\mathit{L}}$ factor often becomes redundant for describing average returns in certain datasets.

Economic bubbles and Bitcoin

Fama has expressed skepticism about the notion that economic bubbles can be identified. He argues that for something to be a bubble, its ending needs to be predicted in real time, not just after the fact. He argues that conventional rhetoric about bubbles proposes no testable propositions and no ways to measure a bubble. Fama has also been skeptical about the long-term viability of bitcoin, citing its extreme volatility, lack of intrinsic value, and violation of basic monetary principles.