'Father of Modern Finance' Explains the Theory Behind Index Funds in 5 Words

Mention the efficient market hypothesis, and the name Eugene F. Fama will instantly come to the mind of any investing expert. Indeed, it was in 1965-1970 that the 2013 Nobel laureate in economic sciences proposed and developed the EMH, a financial breakthrough. 

The University of Chicago Booth School of Business finance professor, 82, has been called the “father of modern finance.” Just one example: The index fund is rooted in his efficient market hypothesis.

In an interview with ThinkAdvisor, Fama concisely explains EMH, argues why active management won’t bring the kinds of returns investors seek, gives the reason he doesn’t see a bubble in the stock market and opines about Bitcoin.

He also discusses the benefits of diversification, which he dubs “your buddy.” 

Teaching at the University of Chicago since 1963, Fama has been the recipient of a wide range of prizes including the Deutsche Bank Prize in Financial Economics, the Morgan Stanley American Finance Association Award for Excellence in Finance and the Onassis Prize in finance.

ThinkAdvisor recently held a phone interview with Fama, who was speaking from Chicago. A consultant to and board member of Dimensional Fund Advisors, his broad investment advice is a crisp: “Hold a diversified portfolio and forget about it.”

Here are highlights of our interview:

THINKADVISOR: Please briefly explain your efficient market hypothesis. It seems complicated.

EUGENE FAMA: It isn’t complicated. It’s a very simple hypothesis: Prices reflect all available information.

Financial behaviorists take a different viewpoint, essentially that prices reflect a number of investor biases, such as overconfidence. Have you modified your view to incorporate theirs?

No. I believe what I see in the data.

What do you think of active management?

It doesn’t pay. [Managers] don’t generate returns. They [just] promise. 

[Finance professor] Ken French and I wrote a long paper on this 10 years ago: Active management doesn’t pay except in very rare cases.

In fact, you were quoted as saying that “making investing decisions based on past performance” is a poor idea. Why?

Think about investment management. This is a well established fact: Winners don’t turn out to be winners over the next five years, and losers don’t turn out to be losers over the next five years. [the outcomes] are [based on] luck.

Yet active management remains very popular among investors. Why is that?

I don’t know. It’s not my problem!

What’s the better way to invest, then? Using index funds?

Yes. Basically, you want to be diversified. Diversification is your buddy. You don’t want to be undiversified. 

So, by definition, if you’re into active management, you’re going to be undiversified because no active management — even the few good managers — can pick out large numbers of underpriced assets.

What should an investor be thinking about when investing their assets, then?

Hold a diversified portfolio and forget about it.