Thursday, January 12, 2012

Eugene Fama - So Full of Win

Check out but a mere handful of Eugene Fama's quality quotes in his mini autobiography of his life in finance:
My grandparents emigrated to the U.S. from Sicily in the early 1900s, so I am a third generation Italian-American. I was the first in the lineage to go to university.
Fans of linear extrapolation confidently predict that his children and grandchildren will soon be solving friendly AI and proving the Reimann Hypothesis.
I went on to Tufts University in 1956, intending to become a high school teacher and sports coach.
Huh! Given the guy is likely to win a Nobel Prize in Economics, I would not have guessed that.
Vindicating Mandelbrot, my thesis (Fama 1965a) shows (in nauseating detail) that distributions of stock returns are fat-tailed: there are far more outliers than would be expected from normal distributions – a fact reconfirmed in subsequent market episodes, including the most recent. Given the accusations of ignorance on this score recently thrown our way in the popular media, it is worth emphasizing that academics in finance have been aware of the fat tails phenomenon in asset returns for about 50 years.
Two points:

1. Spot on with the last part. When people start telling you that all of finance is disproved because returns aren't in fact normally distributed, this should be taken as fairly strong evidence that they are a) a moron, or b) a crank.

2. I love the self-deprecation in the 'nauseating detail'. The unstated implication is 'I have so much kick-@$$ work that I can disparage half of it and nobody will think any less of me.' This assumption has the virtue of being both hilarious and completely true.
The simple idea about forecasting regressions in Fama (1975) has served me well, many times. (When I have an idea, I beat it to death.)...In a blatant example of intellectual arbitrage, I apply the technique to study forward foreign exchange rates as predictors of future spot rates, in a paper (Fama 1984a) highly cited in that literature.
Again, Eugene Fama can say this about Eugene Fama without detracting in any meaningful way from Eugene Fama.
In 1976 Michael Jensen and William Meckling published their groundbreaking paper on agency problems in investment and financing decisions (Jensen and Meckling 1976). According to Kim, Morse, and Zingales (2006), this is the second most highly cited theory paper in economics published in the 1970-2005 period. It fathered an enormous literature. When Mike came to present the paper at Chicago, he began by claiming it would destroy the corporate finance material in what he called the “white bible” (Fama and Miller, The Theory of Finance 1972). Mert and I replied that his analysis is deeper and more insightful, but in fact there is a discussion of stockholder-bondholder agency problems in chapter 4 of our book. Another example that new ideas are almost never completely new!
Translation - Michael Jensen's ideas are almost never completely new [you thieving @#$%].
Though not about risk and expected return, any history of the excitement in finance in the 1960s and 1970s must mention the options pricing work of Black and Scholes (1973) and Merton (1973b). These are the most successful papers in economics – ever – in terms of academic and applied impact. Every Ph.D. student in economics is exposed to this work, and the papers are the foundation of a massive industry in financial derivatives.
I guess some papers are completely new after all! Unlucky, Jensen. (Actually he's generous to Jensen later, but it's still funny.)
What are the state variables that drive the size and value premiums, and why do they lead to variation in expected returns missed by market β? There is a literature that proposes answers to this question, but in my view the evidence so far is unconvincing.
To what extent is the value premium in expected stock returns due to ICAPM state variable risks, investor overreaction, or tastes for assets as consumption goods? We may never know. Moreover, given the blatant empirical motivation of the three-factor model (and the fourfactor offspring of Carhart 1997), perhaps we should just view the model as an attempt to find a set of portfolios that span the mean-variance-efficient set and so can be used to describe expected returns on all assets and portfolios (Huberman and Kandel 1987).
Make sure you point out this passage next time you're forced to sit next to some boring mediocrity droning on about how everyone at Chicago naively and dogmatically assumes that markets are always efficient.

Gold, gold, gold.

(Via Marginal Revolution).

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