Eugene Fama's Contribution to the 2013 Nobel Prize in Economics

What does the Eugene Fama part of the 2013 Nobel Prize in Economics tell us?

This years prize went to Eugene Fama, Lars Hansen and Robert Shiller. All have done work on asset prices - think stock prices.

Fama is the father of the efficient market hypothesis - which states that without consistent inside information it is difficult to determine a better price for a stock other than the current price of that stock.

The argument is that stock prices incorporate all known information into the price of the stock at any given time. Which means that prices will react to new news as it becomes available. That is why they appear to bounce around in a random pattern. Thus the  term "random walk" of stock prices. There are so many people analyzing so much data that it is hard to find an edge. A 7/11/2013 Business Week story on hedge funds says it all:

" In pure dollar terms, there are more resources, advanced degrees, and computing firepower devoted to chasing this elusive goal than almost any other endeavor, and that may include fighting wars. Yet traders face the immutable fact that every second, each megabyte of information, blog post, one-line rumor, revenue estimate, or new product order from China has already been taken into account by the efficient market and reflected in a security’s price. This means that trying to gain what traders call an “edge,” at least legitimately, is almost impossible. As the financial incentives on Wall Street have become enormous, so have the competition and pressure to gain an advantage at any cost."

This means that it is hard to pick stocks that will give you market beating returns. When an investor purchases a stock that he thinks is a good buy, there is a seller who is selling for some reason. What do they know that you dont?

After 2008 many liked to say that the efficient market was dead. Those that said that didnt understand the nuances of Fama's argument:

Fama says that markets dont always get prices correct, sometimes they get prices terribly wrong, but in a random, unpredictable manner, and therefore investors cannot develop systems to consistently outperform the market.

What should an investor do? The answer has been: dont try to time the market or outsmart the market, rather simply own the whole market. By doing so an investor owns the return on capital markets over time. The US stock market has returned around 10% since 1926. Not too bad.

This insight has lead to the growth of index funds over the last 40 years. Index funds allow investors to own the whole market at a very low cost. The lesson for the average investor is to just own the market and stop trying to outsmart all the other smart people. There is not a system to date that has figured out how to outperform the market over the long run (net of fees and taxes).

Note: the stock market fluctuates wildly at times, investors in the market need to understand that point and plan accordingly.