An ‘Aha’ Moment

“In an efficient market, at any point in time, the actual price of a security will be a good estimate of its intrinsic value.” –Eugene Fama

12-07-2020

Eugene Fama is considered the father of modern finance. He brought science to the world of finance and investing. He is best known for his empirical work done in the study of the efficiency of the capital markets. He proved Efficient Market Hypothesis through rigorous empirical testing. In other words, he proved his hypothesis with detailed empirical data. He received the Nobel Prize in Economics in 2013 for his efforts.

His research was a real ‘aha’ moment for me in trying to make sense out of the capital markets and how to invest. Instead of relying on a good story or someone’s opinion of what was going to happen, I know had a scientific approach on how to invest. This changed the way I will invest forever.

Through his empirical testing Fama was able to show that 1) stock prices move randomly, 2) active money managers are not successful at beating the market and 3) prices change quickly based on new information. His work also led to the 5 Factor Model (originally 3 factor model) that he developed with Kenneth French.

On a practical level, this led to the conclusion that low cost index funds are the best vehicles to access the global capital markets. It also made the most sense to tilt portfolios towards the asset classes identified by the 5 factor model as having a higher expected return.

Thanks Gene for your research and giving all investors a scientific method on how to invest.

If you want a more detailed explanation on efficient capital markets check out this video by Ben Felix with Common Sense Investing. Pretty heavy stuff but very thorough. Efficient Capital Markets Explained