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

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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.

But you have to know how to diversify, don’t you?

There are lots of low-cost mutual funds that will do it for you.

When it comes to retirement planning, in addition to diversification, what else should investors keep in mind?

You have to be willing to learn how to make a decision about how much risk you’re [prepared] to bear. That’s very important.

Do you see a stock market bubble?

It depends on what you mean by a bubble. If you mean prices going up and down, then there are bubbles. But if you mean prices going up and down in a predictable way, there’s no evidence of that.

Prices move all over the place in a wide range — the variance of prices. If they’re unpredictable, it’s kind of empty rhetoric to call them bubbles. It doesn’t mean anything. 

It just means they go up and down. When people talk about bubbles, they typically mean that they’re predictable.

Do you pay attention to Bitcoin?

A little bit, not too much. Prices are wild. It’s incredibly risky.

What advice have you for financial advisors?

I’ve talked to financial advisors a lot over many years. Twenty or 30 years ago, I told them that they weren’t going to get away with just being portfolio managers, that they had to have other things going: They had to be experts in all kinds of things, like retirement planning, and that portfolio management wasn’t [enough]. 

That turned out to be true. So almost all of them now have bigger platforms to provide a wide range of financial services.

Do you find that many of your students aspire to become financial advisors?

I don’t know how many of our students become financial advisors. I don’t think it’s such a big number. 

I don’t believe that MBA students in high-level schools end up in that profession. They end up working for financial management companies but not necessarily as financial advisors.

Are you seeing many more females interested in finance?

There’s been a huge shift of females in everything all across the financial business — across all businesses. There were almost no women in the business, and how there’s certainly more than half. 

It’s better for the population as a whole. [Men] have changed [their attitude] or women’s interests have changed — I think it’s some of both. 

It’s very interesting. When I started [at the University of Chicago [in 1963], we had one or two women on our faculty, and now half are women.

Any other thoughts about today’s stock market or the economy?

We’ll see what happens with the changes the current Legislature is trying to put in. We’ll see how it goes in the future. 

I think we’re going to end up with a much bigger government than we have right now. Somebody has to pay for all that.

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