A Prize For All

University of Chicago Professor Eugene F. Fama, Sr., was awarded the prestigious Nobel Prize in Economics last month for his “empirical analysis of asset prices.” This same research inspired Savant’s investment philosophy and process, as well as that of many others. Professor Fama's groundbreaking work in the 1960s and 1970s on asset pricing and markets demonstrated that markets are efficient. Today, he is often referred to as the “father of modern finance.”

His findings eventually led to the development of stock index funds, as he showed that it is highly improbable that we can pick fund managers who will beat markets this year, let alone beat it the next year or the year after.

Efficient Markets Hypothesis
In 1965, he published the Efficient Markets Hypothesis. In his research, Professor Fama realized that financial markets are, at heart, markets for information. Markets are “informationally efficient” as prices on traded assets (such as stocks, bonds, or even real estate) reflect all known information and quickly change to reflect new information as soon as it becomes known.

As investors this means it is impossible to consistently outperform the market, except through luck. In other words, active management strategies are unable to consistently pick stocks that will “outperform” or in any way “time” the markets. This means investors may be better off accepting the market’s rate of return and not taking the unnecessary risks involved with trying to outguess it. As an example, over the past 5 years, almost 80% of all U.S. large cap mutual funds underperformed the market index (S&P 500 Index).1

Professor Fama took these concepts further in 1992 when he published a study on Multi-Factor Asset Pricing Model with Professor Kenneth R. French. They identified two stock risk factors – small companies and value companies – that investors should expect to be compensated for. So a higher exposure in these two areas, in theory, meant a greater long-term expected return.

Your Prize
For our clients, it isn’t important that you understand the fine points of efficient market theory nor the risk factor analysis of small and value stocks. However, it is relevant knowing Savant’s investment philosophy and portfolio process are built on solid, award-winning research.

How do we incorporate the research? 1) Our investment portfolios are primarily allocated to indexed or structured mutual funds/ETFs which invest in the broadest possible set of stocks and bonds in each market segment. 2) The market segments are allocated by risk factors which investors are compensated for, such as incorporating moderate tilts toward small and value stocks which we expect incrementally increases the long-term expected return of the portfolio. Many of the funds we utilize in portfolios are managed by like-minded firms such as Vanguard and Dimensional Fund Advisors (DFA). DFA is a firm whose mutual funds are the direct result of Professor Fama’s work.

So much time today is spent focusing on the latest headline or cover story instead of the time-tested evidence from researchers such as Professor Fama. The important thing to take away is that when we invest using sound principles and discipline, we can all win the prize of reaching our goals.

University of Chicago Booth Professor Eugene Fama talks about the evolution of modern finance (video courtesy of Dimensional)

1S&P Indices Versus Active Funds (SPIVA®) Scorecard report as of 6/30/13.
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