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One of the biggest hurdles investors face is knowing where to access reliable, non-biased stock market research that will point them in the right direction for investing appropriately. Because Nobel laureates have neither the budget nor the intellectual inclination to hire pricey Madison Avenue advertising agencies to promote their astute findings, most investors are unaware of the mountains of peer-reviewed research on investing. Additionally, because their findings run counter to the siren songs for active trading, played by the dozens of brokerage houses churning billions of dollars, investors who want to know the truth have to dig a lot deeper than CNBC. Step 2 of this 12-Step Program for Active Investors provides a comprehensive overview of ample non-biased studies regarding the historical returns of stock market investing. In a nutshell, Step 2 will give you a summary of this research that you won’t see in business magazines, hear on the radio, or see on TV. Here, I cover the objective conclusions drawn from 300 years’ worth of unbiased, rigorous, and empirical research conducted by academics. This body of research discredits the conventional Wall Street wisdom that a stock picker, armed with enough knowledge and research, can consistently beat the market. The open access to such important information rests at the heart of an investor’s ability to understand that active trading is a destructive force that eats away at capital, returns and quality of life. Once an investor recognizes the value of this truly useful information and research available to them, they are well on the road to recovery and real profits. Although this step is titled “Nobel Laureates,” numerous academics will also be discussed who have researched the stock market, but have not been awarded a Nobel Prize.
" Sooner than I dared expect, my explicit prayer has been answered. There is coming to market... something called the First Index Investment Trust.... offering extremely low portfolio turnover; and best of all, giving the broadest diversification needed to maximize mean return with minimum portfolio variance and volatility." Newsweek Magazine, August 1976, also"It is not easy to get rich in Las Vegas, at Churchill Downs, or at the local Merrill Lynch office. "
" Most of my investments are in equity index funds." BusinessWeek and "Why pay people to gamble with your money? "
Question: So investors shouldn't delude themselves about beating the market? Answer: "They're just not going to do it. It's just not going to happen."
Question: I wonder if I might ask you, ...how do you think people should invest for the future...? Should they buy index funds? Answer: "Absolutely. I have often said, and I know this will get some of your readers mad, that any pension fund manager who doesn't have the vast majority—and I mean 70% or 80% of his or her portfolio—in passive investments is guilty of malfeasance, nonfeasance or some other kind of bad feasance! There's just no sense for most of them to have anything but a passive investment policy."
The Nobel Prize is perhaps the most globally recognized honor in each of the fields in which it is presented. To find out what a challenge it is to obtain, you can go to the official web site, or keep reading! The Nobel Internet archive is also a great resource.
Each year the category committees send individual proposals to thousands of scientists, members of academies, and university professors in numerous countries, asking them to nominate Nobel Prize candidates for the coming year. Those considered competent by these committees to submit nominations are chosen in such a way that as many countries and universities as possible will be represented.
The process is very rigorous. Nominations received by each committee are then evaluated with the help of specially appointed experts. When the committees have made their selection among the nominated candidates and have presented their recommendations to the prize-awarding institutions, a vote is taken for the final choice of Laureates.
The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel is awarded at the Prize Awarding Ceremony at the Concert Hall in Stockholm, Sweden, on every December 10th, the anniversary of Alfred Nobel's death.
CRSP Celebrates 50 Years
Why is the University of Chicago so obviously prominent? In 1959, Louis Engel, vice president at the firm then known as Merrill Lynch, Pierce, Fenner & Smith made a phone call. He asked Professor James H. Lorie whether anyone knew how well most people performed in the stock market relative to other investments. Unable to answer the question, Lorie was intrigued. He proposed that Merrill Lynch fund a project with the purpose of gathering, cleaning, and completing the prices, dividends, and rates of return of all stocks listed on the NYSE. Lorie would utilize the new capabilities offered by computers in developing a database to maintain accurate securities information over time. With a complete and accurate database, researchers would no longer need to compile their own data. The project would prove invaluable to empirical research. CRSP is an acronym for the Center for Research in Security Prices, which is located at the University of Chicago. Established in 1960 with a $300,000 grant from Merrill Lynch & Co., CRSP undertook the massive data-gathering project. From 1964 to 1986, the Center received gifts in excess of $1 million from those who yearned for the answer as much as they did. James Lorie became the center's first director, a position he held until 1975. He and Lawrence Fisher, former Associate Professor of Finance and Associate Director of CRSP, collaborated to gather the data. The two colleagues were faced with the monumental responsibility of researching the accuracy of each piece of stock information. They made use of their own formidable training and experience to fill in the blanks for missing stock prices.
The most significant problem investors have is their reliance on factors other than empirical research to select their investments. Investors are mostly speculating and relying on Lady Luck rather than Nobel Laureates. They are most often chasing the recent success of a manager, stock, time, or investment style.
The great majority of investors are unaware of the tremendous amount of academic brainpower that has been applied to investing. This lack of awareness makes investors more susceptible to the lure of active management, engaging in risks they do not understand. There is a stark contrast between a peer reviewed non-biased academic paper and an article in The Wall Street Journal, Barron’s, Forbes, Fortune, Money, an analyst report, or the numerous other sources of investment research. Virtually every private investor is unaware of the vast amount ofacademic research that points to investing in portfolios of index funds.
The solution to the void of investor information is to take a quick walk down the timeline of modern finance. Beginning nearly 350 years ago, I hope this story will lead recovering active investors to a more sound investing strategy--a diversified portfolio of index funds.
Modern economics is built on the pillars of academic research, some of which have led to Nobel Prizes. The following milestones demonstrate how strongly the creativity, determination, and tireless research of thousands of individuals influenced the development of the 12-Step Program to Index Funds.
1654 Blaise Pascal Chevalier de Mere The Early Attempts to Quantify Risk
Modern finance began with the realization that risk needed to be measured and managed. "The intelligent management of risk" can be traced to 1654 during the Renaissance Period. This was a time of great discovery. Centuries-old beliefs were constantly under question and reevaluation. This time of rebirth challenged wizards, mystics, fortune-tellers, oracles, and soothsayers, who were previously regarded as experts on predicting the future. One day in 1654, a French gambler named Chevalier de Mere and a mathematician named Blaise Pascal tried to predict the future outcome of a game of chance.
They wanted to determine how to divide up the stakes of an unfinished game, when one player was slightly ahead. With input from Pierre de Fermat, they developed the theory of probability. This theory is the basis for the concept of risk management and modern finance. Years later in 1952, Nobel Laureate Harry Markowitz embraced what a French gambler had questioned in 1654 and converted it into the theory of Portfolio Selection. His idea revolutionized the investment process!
1690 Edmund Halley Beginning to Understand Risk Management
Edmund Halley, the famous English astronomer who discovered Halley's Comet, began work on a series of life tables in early 1690. A probability based life expectancy could be derived from these tables, which later became the blueprint for the life insurance industry. Techniques of risk management were improved over the years, leading to one of the first commercial applications by the English government. Government officials developed life expectancy tables and sold life annuities, soon followed by marine insurance products. Halley’s work ultimately led to the founding of Lloyd's of London, which originated in a tiny English coffee shop that Halley frequented. These same principles of managing risk were later applied to the stock market. A critical element in the development of risk management was the discovery of standard deviation and the bell shaped curve by Abraham de Moivre in 1730. Francis Galton, cousin to Charles Darwin, proposed the Theory of Regression to the Mean by 1875. This theory predicts that a result will be closer to the "normal" or the expected average over time.
1776 Adam Smith The Wealth of Nations In his 1776 landmark book, The Wealth of Nations, Adam Smith asserted that capitalistic countries would prosper, while non-capitalistic countries would not. His argument was based upon the concept of the invisible hand, the idea that individuals who acted in their own self-interest would benefit society as a whole. By allowing supply and demand to dictate prices, a free market economy would ensure that resources are exchanged in the most efficient manner. Similarly, index fund investing is based on the idea that market prices adjust to reflect current market conditions, and that speculating on future prices is a losing endeavor.
1830 Judge Samuel Putman The Prudent Man Rule In a case of alleged improper management of a trust account, Judge Samuel Putman presided with a decision that has become known as the Prudent Man Rule, still used today to establish proper guidelines for trustees. He stated, "Do what you will, the capital is at hazard. All that can be required of a trustee to invest is that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion, and intelligence manage their own affairs, considering the probable income, as well as the probable safety of the capital to be invested." This was one of the first authoritative and clear statements that risk has to be considered along with return.
1900 Louis Bachelier The Beginnings of Random Walk Theory The year 2000 marked the centennial of the Random Walk Theory of stock market prices. One hundred years since the theory's conception, the overwhleming majority of investors are still not convinced that the markets move in a random fashion. Many scholars confirmed and refined the research of Louis Bachelier, the hapless unsung hero of financial economics. He wrote "The Theory Of Speculation" in 1900 and presented it as his doctoral thesis to the faculty of the Academy of Paris. Bachelier anticipated much of what was later to become standard fare in financial theory: the random walk of financial market prices. "There is no useful information contained in historical price movements of securities."
As is typical with great minds, his professors and contemporaries did not appreciate his innovation. His thesis received humiliating marks from his professors, and he quickly dropped into the shadows of the academic underground. After a series of minor posts, he ended up teaching in an obscure French town for much of the rest of his life. His valuable work was largely ignored until the mid-1960’s when now Nobel Laureate Paul Samuelson unearthed and elaborated on his findings. MIT professor Paul Cootner published a 500-page collection of research reprints on the randomness of the market in 1964. The Random Character of Stock Market Prices contained the first full text English translation of Bachelier's 1900 thesis. Cootner delivered this accolade about Bachelier: "So outstanding is his work that we can say that the study of speculative prices has its moment of glory at its moment of its inception." The Random Walk Theory describes the way stock prices change unpredictably as a result of unexpected information appearing in the market. This "random walk" of changing prices has created a misconception among investors that stock prices change randomly for no rational reason. It is not the changes in stock prices that are random, but the news that is random. News is inherently unpredictable, or it would not be considered news. In reacting rationally to new information, the stock prices look as though they behave in a random fashion. Many others, including Paul Samuelson and Eugene Fama, would later expand on Bachelier’s work. See these two informative articles (pdf format) on Bachelier: 1, 2. 1906 Francis Galton Vox Populi (Voice of the People)
The English scientist Francis Galton, founder of the science of measuring mental faculties, discovered that the wisdom of the many is more accurate than the wisdom of a few. Galton arrived at this discovery in 1906 at a livestock convention where a crowd of about 800 was asked to guess the weight of an ox. Galton added up all of the guesses and calculated the average. The crowd had collectively guessed that the ox weighed 1,197 pounds, just a pound away from the actual weight of 1,198 pounds. While no one individual came as close to the actual weight, the collective crowd’s average estimate hit it almost spot on. From this, Galton concluded that a crowd of regular individuals making independent guesses based on their own independent experiences comes the closest to matching the performance of experts.
The world’s equity markets prove out Galton’s discovery. Millions of investors throughout the world contribute their independent estimates of a stock’s value, resulting in a price that is more accurate than any one individual’s guess. This is the primary reason why indexing works; the market’s price embodies the wisdom of the crowd as it reacts to the news about capitalism.
1932 Alfred Cowles The Standard & Poor's 500 Index
In 1932, Alfred Cowles established the Cowles Commission for Research in Economics with the motto, "Science is Measurement." He also funded the Econometric Society's journal, Econometrica. (see these great papers) The Commission moved to the University of Chicago in 1939 and later to Yale University in 1955, where it was renamed the Cowles Foundation. Almost every U.S. winner of the Nobel Prize in Economics has spent time with the Cowles Commission. In need of a measurement stick, Cowles created a market index in 1938, which became the basis for the 1957 introduction of the Standard & Poor's 500 Index. The goal was to establish a stock market index to represent the average experience of stock market investors. After sweeping failures in forecasting the 1929 crash, the prominent Colorado businessman and investment counselor wanted to focus his considerable statistical skills on analyzing stock market forecasters' ability to choose a portfolio that beats a market average or index. Cowles reviewed approximately 12,000 recommendations and four years of transactions by twenty leading fire insurance companies and published his results in a July 1933 article titled, Can Stock Market Forecasters Forecast? His conclusion was, "It is doubtful." His extensive study of stock market data provided an early demonstration of the "random walk" in stock price movements and the beginning of the Efficient Market Hypothesis. Cowles published a follow-up study in 1944, reviewing 6,900 market forecasts over a period of 15.5 years. Once again, he concluded there was no evidence supporting the ability of the forecaster to predict the future of the market. His studies were the first of over 200 in the area of active manager performance measurements. Cowles determined that despite his research and the research of countless others after him, investors would continue to listen to market forecasters, because they truly wish to believe that somebody, anybody, knows what the future will bring. Most people think that a world in which nobody has a clue is genuinely frightening.
The Cowles Commission in their original Colorado Springs office (more photos.) From left; Professor Gerhard Tintner, Dickson H. Leavens, Dr. Harold T. Davis, Herbert E. Jones, Alfred Cowles (photo courtesy of the Cowles Foundation)
The motto "Theory and Measurement" was first adopted in 1952. It succinctly captures the mission of the Cowles Foundation, which is the development and application of rigorous logical, mathematical, and statistical methods of analysis in economics and related fields. This motto replaced the original Cowles Commission original motto "Science is Measurement," reflecting the importance of theory that became clear early in the history of Cowles. Over the years Cowles scholars have made important contributions to economic theory, to econometric theory, and to a broad range of fields of economics through work that combines economic models with statistical methods of measurement. The mission of "theory and measurement" is reflected in the broad range of Cowles activities today, including those of its four core research programs in Econometrics, Economic Theory, Macroeconomics, and Structural Microeconomics.> Source: Cowles Foundation>
1952 Harry Markowitz, (Also see The Harry Markowitz Page)> Nobel Prize in Economic Sciences, 1990 Efficient Diversification
"Don't bet the ranch. Get more bang for your buck. Maximize output relative to input. Nothing ventured, nothing gained. Diversify instead of striving to make a killing. Don't put all your eggs in one basket; if it drops, you're in trouble. High volatility is like putting your head in the oven and your feet in the refrigerator."
These common sense sayings capture the essence of Harry Markowitz's brainstorm, sparked one afternoon as he sat in the University of Chicago library reading a book about the current thinking of stock market investing. At 25 years old, Markowitz thought investors should be equally concerned with the volatility or risk of investments as they are with the return of investments. Thirty-eight years later, this innovative, practical theory earned him the 1990 Nobel Prize in Economics. This landmark contribution to the investment world was first published in 1952 in an essay entitled, "Portfolio Selection." He later authored a book entitled, Portfolio Selection: Efficient Diversification of Investments (1959). Using several stocks from the New York Stock Exchange, Harry Markowitz created the first efficient frontier. The image below and to the left is reproduced from his book, Portfolio Selection, Cowles Monograph 16, Yale University Press, 1959. It has a line going to the origin, because Markowitz was interested in the effects of combining risky assets with a riskless asset: cash.
Harry Markowitz was primarily concerned with the diversification of risky assets. James Tobin added the concept of combining risk-free assets, such as cash or bonds, with risky assets, such as stocks. His paper, "Liquidity Preference as Behavior Toward Risk" appeared in The Review of Economic Studies in February 1958. The concept he described is known as the Separation Theorem, because it separates Markowitz's approach from the completely different decision of dividing up the whole portfolio between risky and risk-free assets. Tobin also performed an analysis of financial markets and their relationship to expenditure decisions, debt decisions, employment, production, and prices.
1958 Franco Modigliani (left), Nobel Prize in Economics, 1985 (link) Merton Miller, Nobel Prize in Economic Sciences, 1990 The Modigliani-Miller Theorems
The Modigliani-Miller Theorems concern decisions about aspects of the accumulated savings stock. The basic model was formulated in Modigliani's and Miller's essay, "The Cost of Capital, Corporation Finance" and "The Theory of Investment" (1958). Two other important essays followed in 1963 and 1966. Using this basic model, Miller and Modigliani derived two so-called invariance theorems, now known as the MM theorems. As Peter Bernstein asserts, "You have only to mention these letters to finance people, and they know what you mean." The Model of Portfolio Choice and the Capital Asset Pricing Model focus on financial investors, while Merton Miller, initially in collaboration with Franco Modigliani, established a theory for the capital market relationship between the capital asset structure and dividend policy of production firms and firms' market value and costs of capital. The main message of the MM theorems is as follows: a firm’s value is unrelated to its dividend policy, and policy is an unreliable guide for stock selection. The MM theorems have become the comparative norm for theoretical and empirical analyses in corporate finance. Merton Miller, who died in 2001, is the researcher who has dominated these analyses during the last two decades. He has made a unique contribution to modern theory of corporate finance. Also see Debunking Dividend Myths: Part 1 and Part 2.
The Capital Asset Pricing Model defines risk as volatility relative to the market and states that a stock's cost of capital, and the investor's expected return, is proportional to the stock's risk, relative to the entire stock universe. In the mid-1960’s, several researchers worked independently of one another to contribute to the CAPM. William Sharpe's pioneering achievement in this field was contained in his essay, Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk (1964). The expected return on an asset is determined by its beta coefficient, and also measures the similarities between the return on the asset and the return on the market portfolio. The CAPM shows that risks can be shifted to the capital market where they can be bought, sold and evaluated. The prices of risky assets are adjusted so that portfolio decisions become consistent, less random, and less hazardous. The CAPM is the backbone of modern price theory for financial markets. Widely used in empirical analysis, the model allows an abundance of financial statistical data to be utilized systematically and efficiently. It is applied extensively in practical research and has become an important tool for decision making in different areas. Studies require information about firms' costs of capital, where the risk premium is an essential component. The Capital Asset Pricing Model is routinely used in calculations of capital costs associated with investment and takeover decisions, estimates of capital costs for pricing in regulated public utilities, and judicial inquiries related to court decisions regarding compensation to expropriated firms whose shares are not listed on the stock market. The CAPM is also applied to comparative analysis of the success of different investors. Wells Fargo noted in 1989 "that CAPM has given us all a fertile intellectual garden to grow in."
1965 Paul Samuelson, MIT, Nobel Prize in Economics, 1970 (link) The Random Walk Continues Farewell to the Eminent Economist - Paul Samuelson (1915-2009)
Paul Samuelson’s findings can be summarized as follows: Market prices are the best estimates of value, price changes follow random patterns, and future stock prices are unpredictable. (Source: Proof That Properly Anticipated Prices Fluctuate Randomly, Industrial Management Review, Spring 1965) Paul Samuelson was the first American to win the Nobel Prize in Economics. His famous textbook, Economics, was published in 1948 and is now in its 18th edition. He is probably the most famous economist of our time. Samuelson's wisdom is reflected in his words, "Investing should be dull, like watching paint dry or grass grow. If you want excitement, take $800 and go to Las Vegas. It is not easy to get rich in Las Vegas, at Churchill Downs, or at the local Merrill Lynch office." An impressive collection of his research from 1937 to 1986 contains 388 articles that span 4,665 pages. One of Samuelson's idols was Louis Bachelier, the unappreciated genius who first wrote about random prices over a century ago. Samuelson discovered Bachelier’s paper from 1900 in a French library. Like many others, Samuelson proved, expanded, and refined Bachelier's discovery. In Samuelson's 1965 paper, Proof that Properly Anticipated Prices Fluctuate Randomly, he describes "shadow prices" or true values of a security. Samuelson suggests that the best estimate of the true value of a security is the price that is set in the marketplace every minute of every trading day. Although these prices may not be the precise true value, no other estimate is likely to be more accurate than what buyers and sellers agree on in the marketplace. Of course, there is the opposing view of investment professionals who believe that there are constant differences between the market price and the true value of securities, and that those differences can result in future profits for the skilled money manager. Samuelson insists there are no easy pickings and no sure gains. Generally speaking, Paul Samuelson has contributed more than any other contemporary economist to raising the analytical and methodological level in economic science.
1965 (Also see The Eugene Fama Page) Eugene F. Fama, University of Chicago and Dimensional Fund Advisors (link) Efficient Market Hypothesis and the Five Factor Asset Pricing Model
As expected from a University of Chicago graduate and professor, Eugene F. Fama is another pillar of modern finance. Building on the ideas of Bachelier, Cowles, Samuelson, and many others, Fama set out to develop a comprehensive theory to explain why stock market prices fluctuate randomly. He coined the famous phrase "Efficient Market." Fama worked for a stock market newsletter firm while attending undergraduate school in Boston. One of his duties was to find "buy and sell signals" based on certain market trends. He experienced firsthand the difficulty in predicting future market trends. He began to wonder, just as Cowles did before him, why it was so difficult to translate what appeared to be neatly defined past trends into sure methods of making money in the stock market. These ponderings influenced him enough to attend the University of Chicago, obtain his doctorate, and become a professor teaching classes on the works of Harry Markowitz. Despite the innovative character of Markowitz's writings and his association with Chicago, his work was virtually unknown when Fama first brought it to the attention of the finance department. Fama later applied his extensive, world famous research to create numerous index mutual funds at Dimensional Fund Advisors. In January 1965, the Journal of Business published Fama's entire 70-page Ph.D. thesis, "The Behavior of Stock Market Prices," summarized nine months later by the Financial Analysts Journal and titled "Random Walks in Stock Market Prices." Fama suggested that by utilizing the tremendous resources that a major brokerage firm can muster for researching industry trends, effects of interest rates, accounting data, and by talking to managers of firms, consulting economists and politicians, a security analyst should be able to consistently outperform a randomly selected portfolio of securities of the same general risk. Since in any given situation the analyst has a fifty percent chance of outperforming the random selection, even if his skills are nonexistent, Fama's conclusion was that the analysts do not consistently outperform a market. These analysts do help keep the market efficient. If all investors held portfolios of index funds, opportunities would open for active traders to take advantage of the indexed investors. As more active traders moved in to exploit these opportunities, the index advantage would be extinguished and Fama's Efficient Market Hypothesis would once again be evident. The Efficient Market Hypothesis explains the workings of free and efficient financial markets. Information about stocks is widely and cheaply available to all investors. All known and available information is already reflected in current stock prices. The price of a stock agreed on by a buyer and a seller is the best estimate, good or bad, of the investment value of that stock. Stock prices will almost instantaneously change as new unpredictable information about them appears in the market. All of these factors make it almost impossible to capture returns in excess of market returns, without taking greater than market levels of risk. It is relatively rare to find and profit from a mismatch between a stock's price and its value, or to identify an undervalued or overvalued stock through fundamental analysis of stocks. This creates efficient financial markets where most stock prices accurately reflect their true underlying investment values. Even when stock prices do not reflect their values, attempts to establish more accurate values usually cost more than the profit to be made from successful efforts to do so. This theory threatens the view that there might be something pinning down the average price of an asset. Deviations of an asset price from this value follow a random walk. This annoyed those who claim that they could anticipate speculative trends in asset prices. They could not beat a market, because any available information is already incorporated in the price. Anyone with evidence to the contrary has yet to show a comparably rigorous analysis of the facts. At the 1968 Institutional Investor conference, one irate money manager insisted that what he and others did for investors had to be worth more than just throwing darts at the Wall Street Journal. The "dart board portfolio" soon became a new benchmark for active investors, appearing in newspapers, magazines, and in a 1992 20/20 ABC news segment entitled, Who Needs the Experts? In that segment, a giant wall-sized version of the Wall Street Journal was made into a dartboard. Reporter John Stossel threw several darts as he described the firms he randomly hit. The results of that portfolio were compared to those of the major Wall Street Firm experts. The darts beat 90% of the experts! When ABC requested interviews with several of these expert firms, not one of them would speak or comment on their humiliating inability to beat the darts. The Random Walk Theory of stock market prices was detected as early as 1900 by Louis Bachelier and in later studies by Holbrook Working (1934), Alfred Cowles (1933, 1937), Clive Granger with Oskar Morgenstern (1963), and Samuelson (1965). Fama took the theory to new heights with enough rigorous statistical analysis to shake up Wall Street. The biggest problem in getting this information out to the public was that nobody had figured out a way to convert this academic research into a practical product. The entire investment industry profited from the active trading of investment portfolios; even the mutual funds were just very large actively traded portfolios. Today there are index funds incorporating virtually all the research described in this time line. 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. 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.
Additional information: 1. Interviews with Eugene Fama, University of Chicago Finance Professor and Dimensional Fund Advisor`s Director of Research. (Fama Bio) 2. Risk and Cost of Capital (ia-mag.com). New article on cost of capital. 3. A 20 minute video taped interview, scroll down until you see Fama. 4. Fama is rated Number 2 of 105,000 authors in the research paper downloads at ssrn.com. He is author of the number 1 downloaded paper of 30 million downloads.
5. Fama Classic Papers 6. Tufts University Honors Eugene Fama 7. Debate with Thaler 8. Interview with Eugene Fama, Sr. - He covers efficient markets, the zero or negative sum game of active management, diversification, probability machines and why you should be a passive investor. 9. See another interview on Market Efficiency. 10. The Fama/French Forum : Eugene Fama and Kenneth French answer questions about markets.
1965 Michael Jensen (link) Putting Active Management to the Test
Once again from the University of Chicago, Eugene Fama's graduate student, Michael Jensen, published "The Performance of Mutual Funds in the Period 1945-1965," in the Journal of Finance, 1965. This was the first study of actively managed mutual funds that documented their investment professionals' failure to outperform the appropriate market indexes.
Jensen has made significant contributions to the academic literature. Michael Jensen ranks second out of 19,780 authors, at the Social Science Electronic Publishing online database, with over 46,000 downloads of his research papers. A list of other performance measurement articles can be found here. Jensen also added a risk dimension when comparing mutual fund performance. He adjusted returns of funds using Sharpe's volatility measure, beta. This incorporated the idea that investors who take more risk should receive a higher return. Overperformance or underperformance of an index may be due to exposure to more or less risk than a comparable index. Jensen found that if investors had held a broadly based portfolio of common stocks at the same risk level as the mutual funds, they would have earned fifteen percent more. Only twenty-six out of one hundred fifteen funds outperformed the market over the period of the study. Jensen's dramatic study opened the eyes of both the mutual fund industry and investors. He pointed out that fund managers have access to extensive research, and that they do their jobs every day with wide ranging contacts and associations in both the business and financial communities. This begs the question: if the experts cannot do better than an index, who can? Jensen's study did not consider the federal and state taxes on the realized gains generated by the high turnover of these mutual funds. That problem was later studied by Robert Arnott in his paper, "Can Your Alpha Cover Your Taxes?" Alpha refers to a manager's return in excess of a market. When adjusted for all relevant factors, a well defined index of stocks will always outperform the high cost of active manager trading within that index. The only way to get a return that is different from an index is to invest in a portfolio that is different from the index. Since the index is the only source of long-term risk and return data, why would an investor choose anything else? 1971 John McQuown, Wells Fargo Bank (link) The First Index Fund John McQuown joined the Wells Fargo Bank Management Science division in 1964. He was recruited by the division's president to implement modern portfolio theories in the bank's trust department. McQuown had learned about these new theories through his acquaintances at the University of Chicago - Fisher, Lorie and Fama. Although McQuown had a degree in Mechanical Engineering, he soon became more interested in applying computer science to the stock market. In revamping the trust department, he called on numerous academic consultants, including Markowitz, Sharpe, Fama, Miller, Lorie, Jensen, Scholes, Black and Treynor. John McQuown, James Vertin, and William Fouse developed the first commercial product that actually applied the academic theories developed in Chicago. In 1971, the son of the owner of Samsonite Luggage Corporation completed his graduate studies at the University of Chicago's Department of Finance. When he returned to Denver, he wanted to apply what he had learned to Samsonite's pension fund. His contacts in Chicago put him in touch with Wells Fargo Bank in San Francisco. As a result, Samsonite invested six million dollars of the company's pension fund into the very first index fund. That first institutional fund was not based on the S&P 500, but was comprised of an equal dollar amount of each of the 1,500 stocks on the New York Stock Exchange.
1973 John McQuown, Wells Fargo Bank (link) Rex Sinquefield (shown below), American National Bank The Standard and Poor's Composite Index Funds
John McQuown at Wells Fargo and Rex Sinquefield at American National Bank in Chicago both established the first Standard and Poor's Composite Index Funds in 1973. Both of these funds were established for institutional clients; individual investors were excluded. Wells Fargo started with $5 million from their own pension fund, while Illinois Bell put in $5 million of their pension funds at American National Bank. In 1981, Rex Sinquefield became chairman of Dimensional Fund Advisors (DFA), and McQuown joined its Board of Directors. DFA further developed index-based investment strategies and currently has $136 billion under management. Wells Fargo sold its indexing operation to Barclay's Bank of London, and it now operates as Barclay's Global Investors. It is one of the world's largest money managers with over $1.4 trillion under management.
1973 Burton G. Malkiel (link) A Random Walk Down Wall Street
Also in 1973, Burton G. Malkiel published his book, A Random Walk Down Wall Street, which clearly lays out several of the principles of the academic research described above. He presents these theories to the private investor, even making a plea to any institution to sponsor an index fund. "Fund spokesmen are quick to point out you can't buy the market averages. It's time the public can." Two years later on December 31, 1975, Vanguard created the First Index Investment Trust, and Burton Malkiel joined the Vanguard Board of Directors in 1977. John Bogle has referred to him as a spiritual leader of the crusade. On October 13, 2008, Professor Malikiel wrote an article for the Wall Street Journal and stated, "It is very tempting to try to time the market. But neither individuals nor investment professionals can consistently time the market." - Keep Your Money in the Market. On February 5, 2010, the New York Times reviewed the new book by Burton Malkiel and Charles Ellis. In the article the author states that "Mr. Malkiel, a professor of economics at Princeton University, has long advocated index funds. What’s striking now is his belief that the wealthiest would have fine returns without the volatility and high fees if they simply used indexes to diversify their money across asset classes. “This is still a strategy that is good for people of all income levels,” he said. “If I took all the mutual funds that existed in the early 1970s and asked the question how many really beat the market through 2009, you can count them on the fingers of one hand." The Index Funds Gospel According to Burton Malkiel. guardian.co.uk
1975 John Bogle, Chairman, The Vanguard Group (link) The First Index Mutual Fund for the Private Investor
John Clifton Bogle graduated from Princeton (not Chicago!) in 1951, where his senior thesis was titled: "Mutual Funds can make no claims to superiority over the Market Averages." Bogle claims his inspiration came from three sources, all of which confirmed his 1951 research: Paul Samuelson's 1974 paper, "Challenge to Judgment," Charles Ellis' 1975 study, "The Loser's Game," and Al Ehrbar's 1975 Fortune magazine article on indexing. Bogle founded The Vanguard Group in 1974; it is now the third largest Mutual Fund Company in the world.
Vanguard has 140 mutual funds and assets totaling $1.1 trillion. When Bogle started the First Index Investment Trust on December 31, 1975, it was labeled "Bogle's Folly" and regarded as un-American, because it sought to achieve the averages rather than insisting that Americans had to play to win. This first Index Mutual Fund offered to individual investors was later renamed the Vanguard 500 Index Fund, which tracks the Standard and Poor's 500 Index.
It started with comparatively meager assets of $11 million but crossed the $100 billion milestone in November 1999, an astonishing growth rate of fifty percent per year. Bogle predicted in January 1992 that it would very likely surpass the Magellan Fund before 2001, which it did in 2000. "But in the financial markets it is always wise to expect the unexpected" (Bogle speech 1998).
1981 David G. Booth, Co-Chairman Dimensional Fund Advisors (link) A New Frontier of Investing David Booth graduated from the University of Chicago in 1971, naturally exposed to minds such as Eugene Fama, Merton Miller, and Kenneth French. In the years before starting his own company, Booth came to believe that people were missing out on some of the importance of the market efficiency story.
Twenty-five years of scientific research convinced Booth that academic study gave investors an advantage, providing information about products that are underserved, or those that were not already on the market. Understanding the vital relationship between risk and return was also facilitated by this scientific approach. In 1981, Booth made room in his two-bedroom apartment for a Quotron machine. Determined to explore new frontiers of investing, he founded Dimensional Fund Advisors (DFA). DFA is significant because it was one of the first companies to impart the idea of equilibrium and the concept that a scientific method can show the direct relationship between risk and return. DFA has continued to succeed, even during the 1980's when small cap stocks were at their worst. In January 2009, DFA completed construction of its new, state of the art, world headquarters in Austin, Texas. As of September 30, 2011, the firm manages $195.3 billion in assets. On November 6, 2008, the University of Chicago Graduate School of Business announced a $300 million dollar gift from David Booth. This is the largest donation in the University's history and the largest gift to any business school in the world. The school was renamed the University of Chicago Booth School of Business. The Chicago Booth School of Business made the announcement on this page.
Nov 6, 08 Update
David Booth, President of Dimensional Fund Advisors, gives the largest gift to any University in history, $300 Million. See this video.
1990 William F. Sharpe (left), Nobel Prize in Economic Sciences, 1990 (link) Merton H. Miller, Nobel Prize in Economic Sciences, 1990 Harry M. Markowitz, Nobel Prize in Economic Sciences, 1990 Nobel Prize Site The Science Of Investing Is Recognized
On October 16, 1990, the Alfred Nobel Memorial Prize in Economic Sciences acknowledged the role of science in investing and awarded the prize to Harry M. Markowitz of the City University of New York, William F. Sharpe of Stanford University and Merton H. Miller of the University of Chicago for their pioneering work in the field of financial economics. The science of investing, which began with Alfred Cowles back in 1933, was formally recognized that year. This occasion marked a milestone, since it formally recognized the continuing revolution in investment theory and practice that was sparked nearly forty years ago. All equally deserving, William Sharpe was rewarded for the Capital Asset Pricing Model, beta and relative risk; Harry Markowitz for the theory of portfolio selection; and Merton Miller for work on the effect of a firm's capital structure and dividend policy on market price. 1992 Eugene Fama, University of Chicago (link) Kenneth French (shown below), University of Chicago (currently MIT) The Three-Factor Asset Pricing Model
In June 1992, Eugene Fama and Kenneth French of the University of Chicago published Size and Book-to-Market Equity: Returns and Economic Fundamentals. Their research improved on William Sharpe's single factor asset-pricing model (CAPM). By identifying market, size, and value factors in returns, they developed the three-factor asset pricing model. It is an invaluable tool for asset allocation and portfolio analysis. This revolutionized the way we construct and analyze portfolios by identifying independent sources of risk and return. They introduced the first concentrated, empirical value strategies. This research led to similar findings internationally, and they updated their studies in 1998 to include data from as far back as 1929. Kenneth French speaks on tech ticker:
A 'Stock Picker's Market?' Keep Dreaming
The tumultuous stock markets with their many new instruments and novel approaches to investing are a dramatic contrast from the quiet academic libraries where the academics created their revolution. Considering the extent of the academics’ research, we know that it deserves to be considered a superior source of information for making decisions concerning investment portfolios. Random and efficient markets have been one of the underlying themes throughout this step. Under these conditions, a mix of index funds must be the best and most logical conclusion for investors.
Now that you have learned a little about the individuals and institutions that contributed to our current knowledge of Modern Portfolio Theory, you are ready to move on to Step 3 to confirm why stock picking just doesn't work.
Please answer the following questions before moving on to the next Step:
1. Who first proposed in the year 1900 that stock market prices are random?
2. Modern Portfolio Theory is not so modern because Harry Markowitz first introduced one of the basic tenets in:
3. The three factors of Fama and French's three-factor model are: