Debate about market efficiency is forever. That includes the ocassional commentary from the man who started it all, or at least played a pivotal role in bringing the idea to the financial fore, starting in the 1960s. What’s it all about? You could spend the better part of a year reviewing the academic literature, and the remainder of the decade catching up on the various threads of discussion–pro, con and everything in between. For the short, short, short recap, a line from Peter Bernstein’s classic Capital Ideas sums up Eugene Fama’s research as well as anyone, particularly the early work: “Fama’s point is that, on the average, information moves so fast that the market as a whole knows more than any individual investor can know.”
But within that reasonable, but far from universally accepted notion lies a universe of nuance and just as much argument over the details. That includes our own view on synthesizing a whole from the disparate parts via Dynamic Asset Allocation. Meantime, Fama’s latest effort to opine on market efficiency comes by way of a request from the Annual Review of Financial Economics for a professional autobiography. Fama’s response can be read here. As for the excerpt that caught our eye, read on…
Vindicating Mandelbrot, my thesis (Fama 1965a) shows (in nauseating detail) that distributions of stock returns are fat-tailed: there are far more outliers than would be expected from normal distributions–a fact reconfirmed in subsequent market episodes, including the most recent. Given the accusations of ignorance on this score recently thrown our way in the popular media, it is worth emphasizing that academics in finance have been aware of the fat tails phenomenon in asset returns for about 50 years.
My thesis and the earlier work of others on the time-series properties of returns falls under what came to be called tests of market efficiency. I coined the terms “market efficiency” and “efficient markets,” but they do not appear in my thesis. They first appear in “Random Walks in Stock Market Prices,” paper number 16 in the series of Selected Papers of the Graduate School of Business, University of Chicago, reprinted in the Financial Analysts Journal (Fama 1965b).
From the inception of research on the time-series properties of stock returns, economists speculated about how prices and returns behave if markets work, that is, if prices fully reflect all available information. The initial theory was the random walk model. In two important papers, Samuelson (1965) and Mandelbrot (1966) show that the random walk prediction (price changes are iid) is too strong. The proposition that prices fully reflect available information implies only that prices are sub-martingales. Formally, the deviations of price changes or returns from the values required to compensate investors for time and risk-bearing have expected value equal to zero conditional on past information.
During the early years, in addition to my thesis, I wrote several papers on market efficiency (Fama 1963, 1965c, Fama and Blume 1966), now mostly forgotten. My main contribution to the theory of efficient markets is the 1970 review (Fama 1970). The paper emphasizes the joint hypothesis problem hidden in the sub-martingales of Mandelbrot (1966) and Samuelson (1965). Specifically, market efficiency can only be tested in the context of an asset pricing model that specifies equilibrium expected returns. In other words, to test whether prices fully reflect available information, we must specify how the market is trying to compensate investors when it sets prices. My cleanest statement of the theory of efficient markets is in chapter 5 of Fama (1976b), reiterated in my second review “Efficient Markets II” (Fama 1991a).
The joint hypothesis problem is obvious, but only on hindsight. For example, much of the early work on market efficiency focuses on the autocorrelations of stock returns. It was not recognized that market efficiency implies zero autocorrelation only if the expected returns that investors require to hold stocks are constant through time or at least serially uncorrelated, and both conditions are unlikely.
The joint hypothesis problem is generally acknowledged in work on market efficiency after Fama (1970), and it is understood that, as a result, market efficiency per se is not testable. The flip side of the joint hypothesis problem is less often acknowledged. Specifically, almost all asset pricing models assume asset markets are efficient, so tests of these models are joint tests of the models and market efficiency. Asset pricing and market efficiency are forever joined at the hip.