By KENNETH R. FRENCH
Bayes rule is a way to update your model of the world when you have new information. Suppose we are interested in assessing the probability that a specific hypothesis is true. We start with an initial assessment, called our prior, which is based on all the data we have observed, books we have read, and our other life experiences. This post explains how we should update our initial assessment when we observe new data.
In this video, Andrew Lo—Professor of Finance at MIT Sloan—speaks with Eugene Fama about the arc of Gene’s empirical and theoretical research. The topics covered in this interview range from Gene’s PhD dissertation on The Behavior of Stock Market Prices which laid the groundwork for the Efficient Markets Hypothesis, to tests of the Capital Asset Pricing Model that ultimately set the stage for the Fama-French Three Factor Model in 1993. Andrew and Gene also discuss the application of financial research at Dimensional. The interview concludes with a forward-looking discussion on whether a “perfect portfolio” can be constructed, as well as Gene’s reflections on the Fama-French Five Factor Model (2014).
Please do not quote. To accompany the forthcoming book, In Pursuit of the Perfect Portfolio by Steve Foerster (Ivey Business School at Western University) and Andrew W. Lo (MIT).
The efficient markets hypothesis (EMH), developed by Eugene Fama in the 1960s, simply states that prices reflect all available information. Despite its simplicity, the EMH has been difficult to test and generated decades of debate. In this video, Gene and Richard Thaler, a founding father of behavioral economics, discuss whether markets are efficient. Despite some areas of discord, Thaler sums up an important point of agreement: “Stock markets, good or bad, are the best thing we got going. So, nobody’s devised a way of allocating resources that’s better.”
Long/Short (LS) strategies buy one equity portfolio and short another. They are often sold as a way to add a premium with special diversification benefits that arise because the premium is not highly correlated with the rest of an investor’s equity portfolio. We provide examples to show how to evaluate these claims.
Portable alpha is the return from an active investment strategy that has no exposure to some index, such as the S&P 500 or the Russell 2000. It is often sold as a way to get the benefits of active management at lower cost. For the moment we leave aside whether there are benefits to active management and focus on the claim about costs.
EFF/KRF: Our strategies for choosing papers are similar. Sometimes we don’t have a choice. If we agree to referee a paper or discuss it at a conference, we are certain to read it, and we read most of the papers our colleagues write.
David Booth, chairman and co-CEO of Dimensional Fund Advisors, has been working with Eugene Fama since the mid-1960s. David was a PhD student in Gene’s class and later asked Gene to become a board member when Dimensional got off the ground in 1981. Gene is the principal scholar whose groundbreaking work inspired the firm’s founding, continues to advise the firm on many of its strategies, and is also a frequent speaker at Dimensional conferences and seminars. In this video, they discuss Gene’s early influences, the history of modern finance, the longtime collaboration between Gene and Ken French, the philosophy underlying Dimensional’s approach to investing, financial advisors, the five-factor model, Gene’s Nobel prize, and more.
EFF/KRF: The short answer: usually almost nothing.
EFF/KRF: Unfortunately, daily returns don’t provide more information.
EFF/KRF: There is some confusion about the interpretation of the evidence in Fama and French (2014, “A Five-Factor Model of Expected Returns”) that HML is redundant for explaining average U.S. stock returns for 1963-2013.
Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.