Secrets of Financial Success
It may or may not have escaped your notice that on Monday this week, this year’s Noble Prize in economics was awarded to three American economists; Eugene Fama, Lars Peter Hansen and Robert Shiller, who have spent their academic lives looking at stock market pricing concepts in different ways.
Why should that be worthy of this blog? Well, Eugene Fama has made a very big impact on how your personal portfolio is structured. How you may well ask?
Well in the 1960s, he developed the Efficient Market Hypothesis that suggests that market prices react quickly to new previously unknown information, implying that any subsequent price movement must essentially be random as the availability of new information is random. If the hypothesis holds true, then trying to beat the return of the market is an exercise in futility. The numerous empirical studies undertaken on active manager performance – those trying to beat the market – bear this out to a compelling degree. An institutional passive approach – capturing market returns – makes very good sense.
In 1992, along with Ken French, he also wrote a seminal paper on the incremental returns, relative to the market, that have been delivered by investing in value – less financially healthy – companies and smaller companies. Investors owning market-cap weighted funds tend to own predominantly larger and often growth companies. This paper provided a framework for structuring more diversified portfolios, by making incremental allocations – or ‘tilts’ as they are often known – to value and smaller companies, with the expectation of capturing a higher rate of return than the market, for the incremental risks taken on.
This work inspired the foundation of Dimensional Fund Advisors (DFA), on whose Board he still sits.
His thinking – along with others – has provided us (and many advisers and institutional investors worldwide) with a sound, risk-based approach to constructing well diversified portfolios implemented using well-managed passive funds.
Sometimes we touch greatness in surprising ways – this is one. We congratulate him on his worthy – and long overdue – honour.
If you would like to see Eugene Fama talking briefly about the evolution of finance, follow the link below: