The 2013 Nobel Prize winner were announced. The winners for economics were Robert Shiller, Lars Peter Hansen and Eugene Fama.
Mr. Fama has long been a well-regarded proponent of the theory of efficient-markets. That is, he believes that eventually markets will revert back to their norm. He has been a large proponent of investing in index funds. Basically, the theory is that equity markets are efficient and that prices might fluctuate, but they will eventually revert back to an appropriate pricing level. Others have punched holes in the theory stating that human beings’ behavior impacts stock performance and pricing doesn’t necessarily revert back.
The efficient-market hypothesis was developed by Professor Eugene Fama at the University of Chicago Booth School of Business as an academic concept of study through his published Ph.D. thesis in the early 1960s at the same school. It was widely accepted up until the 1990s, when behavioral finance economists, who had been a fringe element, became mainstream. Empirical analyses have consistently found problems with the efficient-market hypothesis, the most consistent being that stocks with low price to earnings (and similarly, low price to cash-flow or book value) outperform other stocks. Alternative theories have proposed that cognitive biases cause these inefficiencies, leading investors to purchase overpriced growth stocks rather than value stocks. Although the efficient-market hypothesis has become controversial because substantial and lasting inefficiencies are observed, Beechey et al. (2000) consider that it remains a worthwhile starting point. source: wikipedia
Mr. Fama argues that it is futile for individuals to purchase stocks and that they are better off just investing in index funds. Index funds are incredibly inexpensive investing vehicles. For instance, the SPDR S&P 500 (ticker symbol: SPY) has an expense ratio of only 0.09% and if you purchase the Schwab ETF version of the broad USA stock market named the Schwab U.S. Broad Market ETF (ticker symbol: SCHB), it charges just 0.04% as an expense ratio. What’s more, if you are a Schwab customer, you can purchase this ETF commission-free at Schwab. Fidelity and Vanguard have similar deals as well.
One of the biggest advantages of index investing is the ease with which you can invest. Also, you are not subject to major pricing swings that individual stocks are. Index investing is a valid strategy, but it do have its drawbacks, mainly that the stock markets are not always efficient. However, it is possible to head off difficulties in the stock market if you are willing to follow the markets. One thing that investors should watch out for is the sector weightings of the S&P 500. When one particular sector grows and gets to 30% of the S&P 500, as the technology sector did in 2000, and as the energy sector did in the early 1980s, it’s usually a pretty good warning sign that pricing trouble is one the way. If you heed this warning signs, you can adjust your portfolio accordingly.
Should investors follow Mr. Fama’s suggestions and investing in index funds? That’s really a personal choice. If you are willing to follow the stock markets and believe that you can do better, you might want to give it a try. However, don’t be surprised if you find yourself underperforming the markets.
So Mr. Fama has been a big believer in the efficient-market hypothesis and he has been awarded another Nobel Prize in Economics for his work on this topic. Congratulations Mr. Fama.