The award of the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel to Eugene Fama (along with Robert Shiller and Lars Peter Hansen) has prompted a number of economists and finance professionals to note that Fama's work on the efficient market hypothesis underlies the buy-and-hold-the-market strategies embodied in a number of mutual funds, of which the Vanguard Index 500 has long been the flagship. We have been treated to another round of stories about how hard it is to beat the market. Fine. Let's remember the principle of the margin, though. The efficient market hypothesis assumes that there exists a fairly numerous group of people trying to spot potential arbitrage opportunities and to take advantage of them. Index funds and active investors act as checks on each other. If everybody is a passive index investor, there are opportunities for analysts to generate insights that nobody else is generating and to use them as the basis for profitable trades. If everybody is an active trader, given how many people do not have new insights to generate, some (most?) are better off giving up the small chance of sustained above-average returns for the certainty of lower fees. The underlying point to remember is that market efficiency is not something that happens automatically. It is the result of ceaseless activity by many people. Some of them are bright enough to beat the market, not by holding every stock on the market but by specializing in certain segments. The Forbes 400 list has quite a few hedge fund operators on it. As I interpret the implications of the efficient markets hypothesis for investing, it is that some people can beat the market consistently because they really do have superior insight. Warren Buffett was not just lucky; he reads financial statements with the enthusiasm that other people reserve for pulp novels. Most of us are better off riding on the efforts of others, though, just as we are better off not doing our own plumbing or our own songwriting. And if you are reading this now rather than plowing through corporate financial statements, you are very likely part of that great majority.
ADDENDUM: As John Bogle of Vanguard has remarked, he was unaware of Fama's work when he developed index funds at Vanguard. Bogle's motivations were the high fees and lack of diversification he saw in existing financial products; he thought he could do better, and he did. I was aware of this, hence I did not say that Fama influenced Vanguard. It's an interesting case of how an insightful businessman and an insightful academic reached the same result by different routes.
