Why was this? Fama reasoned that the pricing mechanism of markets — what you or I would call trading — efficiently reflected all known information about stocks. Buying and selling created an “informational efficiency.” If there were any significant details known about a company, someone would discover it eventually and act on that information. Hence, all known data that exist about a company are reflected in its stock price. The Efficient Market Hypothesis, as Fama called it, meant that stock-picking was a futile exercise. He described the details in a 1965 paper titled “Random Walks in Stock Market Prices.”
The relevance to finance was soon obvious: Most investors are better off owning the entire market, rather than guessing which stocks might do better or worse. We can quibble with some of Fama’s reasoning. It turns out that prices are not all that rational and frequently deviate from known data — but Fama got the big concept right: Markets behave unpredictably in the short term.
For this, Fama is thought of as the intellectual father of indexing. The entire concept of passive investing in indexes grew around his insights. His work became hugely influential, and remains so to this day. If you own a Standard & Poor’s 500-stock index, you do so because of Fama the Younger’s observations.
Had he stopped there, Fama the Younger probably would have flown to Sweden to pick up his Nobel Prize money decades ago.
But the years went by, and Fama kept coming back to his hypothesis. He pushed it to all manner of odd places. So the Nobel committee was confronted with the problem of Fama the Elder — the second Eugene Fama. That professor built on his own work. The influence of his insight imbued the Elder with prestige far beyond what his latter flawed work should have generated. It allowed him to expand his efficient-market thesis. That, dear readers, is where our boy ran into trouble.
Fama the Elder took the idea of efficient markets to an illogical extreme. He made a leap of faith based largely on the earlier flawed analysis that led him to the correct conclusion that markets behave randomly. Because markets reflect all known information in their prices, Fama rationalized, most of the rules and regulations related to securities were unnecessary. Even worse, he reasoned, they were counterproductive because they interfered with the price discovery process.
Insider trading rules? We don’t need them! Why would we, when even nonpublic information known to insiders is reflected magically in stock prices! Indeed, we can eliminate nearly all of the rules that have been developed since the Great Depression to regulate investing and trading. After all, Fama argued, with all information reflected in the price, these rules are superfluous.