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Please do not quote.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.”
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.
Investors tend to overweight their equity portfolios with stocks from their home country market. Ken French says that, while home bias is still the norm, investors have significantly increased their allocation to foreign markets over the last 30 years. He explains that investors might overweight their home market for economic reasons, perhaps to hedge consumption risk or to offset tax disadvantages they suffer in some foreign markets. Home bias can also be driven by behavioral factors. For example, investors may overweight their home country because of their uncertainty (the unknown unknowns) about foreign markets, or because they are overconfident about picking stocks in their home market. Ken says the best approach is to start with a global market portfolio, then make adjustments based on personal preference.
Should retirees limit their spending to the interest and dividends they receive? Ken French says investors should be indifferent to how they raise cash, whether through dividends and interest, or through the sale of shares--a method Merton Miller called "homemade dividends." Despite the economic logic, some investors focus on dividends and interest. While this approach may encourage disciplined spending, Ken explains that it also can distort one's investment approach--for example, when investors choose dividend-paying stocks over broad diversification, or chase higher yields by holding riskier bonds. In an effort to get more, they actually lose.
Ken French says the simplest answer is found in the rate offered on a long-term Treasury Inflation Protected Security (TIPS). You can go beyond the TIPS rate if you don't plan to live forever. Retirees with a shorter life expectancy might choose to consume more. Finally, you might increase your expected investment return and your expected sustainable withdrawal rate by taking more risk. But Ken warns that the expected return and the return you ultimately receive could be very different. That is the nature of risk.
Can investors build a better portfolio by combining asset classes that have low correlations? It is possible, explains Ken French, but not in the way that most investors attempt it. Some think they can enhance diversification by eliminating mid caps and concentrating on only large and small cap stocks because these asset classes are less correlated. Ken explains that portfolio variance is determined not only by correlation, but also by variance of the individual asset classes and, critically, by their weighting in the portfolio. He emphasizes that throwing out mid caps is equivalent to doubling up on the risk of large and small caps, which is the opposite of diversification.
Can principal-guaranteed products help an investor better manage portfolio risk? Ken French explains that principal protection would certainly be attractive if it were free. Unfortunately for investors, it is not. French discusses potential problems with principal-guaranteed products and argues that before purchasing these instruments investors should consider portfolio solutions that are simpler, transparent and more cost effective.
Rising government spending around the world has many investors considering ways to hedge potential inflation, which may include holding TIPS or rolling over short-term Treasury securities. Ken French explains that investors can essentially eliminate inflation uncertainty by buying TIPS that mature when they want to consume. However, uncertainty about changes in real interest rates can make the choice harder for investors who will have to sell their TIPS before maturity.
In this video, Kenneth French explains why lower economic growth may not hinder future stock returns. In fact, history shows that average returns tend to be higher during periods of economic difficulty. The information about a current recession is factored into stock prices, and investors may require a higher expected return to induce them to take higher perceived risk.
This video, recorded at the Chicago Booth 2010 Management Conference, features Eugene Fama and David Booth providing insights into what lies ahead for active and passive money management.
EFF: I was interviewed on CNBC's "Squawk Box" this past Friday about the recent financial crisis and financial regulatory reform.
From the American Finance Association's "Masters in Finance" video series, Eugene F. Fama presents a brief history of the efficient market theory. The lecture was recorded at the University of Chicago in October 2008 with an introduction by John Cochrane.
In an interview conducted by Professor Richard Roll, famed University of Chicago economist Eugene F. Fama discusses his life, research, and contributions to the field of finance. Produced by Dimensional in conjunction with the American Finance Association. Directed and edited by Gene Fama Jr.
Widely cited as the father of the efficient market hypothesis and one of its strongest advocates, Professor Eugene Fama examines his groundbreaking idea in the context of the 2008 and 2009 markets. He outlines the benefits and limitations of efficient markets for everyday investors and is interviewed by the Chairman of Dimensional Fund Advisors in Europe, David Salisbury.
The answer depends on why stockholders want to leave the market. During the financial crisis, some investors discovered that their tolerance for risk is lower than they thought, so it might make sense for them to permanently reduce their exposure to equities. Investors who wish to avoid the price impact of the recession, however, are probably too late. Today's stock prices already reflect the anticipated effects of the slowdown, as well as any effects the recession has on expected future returns.
Investors may doubt the usefulness of diversification after the recent market decline. In this video, Kenneth French explains that diversification cannot reduce the volatility of the overall market, but it is still important because it reduces the risk associated with individual firms or asset classes. He also discusses the perception that correlations between assets rise when market volatility is high.
Does it make sense to dollar cost average? It depends. Standard financial analysis says dollar cost averaging is suboptimal. If you focus on only your investment outcome, investing a lump sum immediately lets you construct the best portfolio you can today; slowing the process with dollar cost averaging just keeps you in something other than your best portfolio until you are done. Behavioral finance provides a different perspective. Because of the difference between the way people react to errors of omission and errors of commission, dollar cost averaging may give investors a better expected investment experience.
Although it would be great if we could all hire above average active managers, that only happens in Lake Wobegon. Superior managers may exist, but most investors might as well be picking their managers at random. I describe the challenge of differentiating luck from skill, and explain how intense competition among investors makes the problem even more difficult.
KRF: I explain why active investing is always a negative sum game. We often hear that now is a good time (or a bad time) for active investing. That does not make sense. In aggregate, active investors always underperform by their fees and expenses.
KRF: What does it mean to say there is a flight to quality? For every seller there must be a buyer. After exploring this simple point, I explain how expectations about future cashflows and future returns affect the current price.
Fama speaks candidly about academic progress, smart beta, and the efficient markets hypothesis.
Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.