Read the following article and then answer to the questions below. Original link: https://www.marketwatch.com/story/nobel-winner-eugene-fama-on-bubbles-why-indexing-is-still-king-and-gamestop-11614776294

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Nobel winner Eugene Fama on GameStop, market bubbles and why indexing is king
Famed finance professor says no investor should ‘play that game where you’re speculating in individual assets.’

Starting in the 1960s, Eugene Fama formulated and proved through data and statistical analysis the “efficient market theory.”

It became the foundation of finance for the next half-century and provided the rationale for index funds, which now comprise the majority of equity assets.

MarketWatch recently interviewed Fama about some of the wild things going on in today’s markets, and, spoiler alert: He still believes his theory.

On the day he won the Nobel Prize in 2013, Fama taught his class at the University of Chicago Booth School of Business, because, he said, “I had never missed a class in all the years I’d been teaching. I wasn’t going to start now.” At 82, and having been on the faculty since 1963, he still hasn’t.

Howard Gold: In a 1976 book you wrote, “The prices of securities observed at any time are based on correct evaluation of all information available at that time. In an efficient market, prices fully reflect available information.” I’m assuming that’s still the foundation of your thinking.

Eugene Fama: That’s the definition of efficient markets. What the research is all about is testing to what extent that’s true. For the most part, the model looks very good in the data. For example, if you look at mutual funds, it’s very difficult to find any funds that have actually beaten their benchmarks on a statistically reliable basis.

Gold: Hedge funds supposedly have the best information and the most advanced computers, the most sophisticated algorithms, but–

Fama: They fail with ruthless regularity.

Gold: And they charge good money for it, too.

Fama: Right.

Gold: But if “the market accurately reflects all information,” why have some active investors beaten the market for long periods of time? Managers like Bill Miller, Bruce Berkowitz, and Peter Lynch did for 10-15 years. Warren Buffett did for 40 years or so. (Nearly all subsequently underperformed.) How do you explain outperformance like that?

Fama: Chance alone can generate big winners when there are a lot of people playing the game. For somebody to throw 15 heads in a row, it’s very low probability to identify, say, “That person will throw 15 heads in a row.” But if you say, “Yeah, I looked at 25,000 investors, and this guy threw 10 heads in a row,” well, that’s not so unlikely anymore, because with that many throws of the die, somebody is going to come up and do it, strictly by chance.

Gold: Is it just pure luck, or do some managers spot a market trend early, ride it for a decade or so, and then after that, they can’t do anything?

Fama: You can’t really tell, because we’re always looking after the fact. Ken French [of Dartmouth College] and I, in our mutual funds study, said, “If I look at the whole cross-section of thousands of mutual funds, is the distribution of outcomes different than what you would expect by chance?”

Gold: What did you find?

Fama: If you look at them after costs, they’re awful. If you look at them before costs, then there’s some evidence that there are winners. But unfortunately, before costs is not what goes to investors; investors get after-cost returns. After the fact, it’s worse than chance, because the fees and expenses are a killer.

Gold: So, you don’t think there’s anyone who can be reliably predicted to beat the market, after costs?

Fama: There might be somebody there, but I don’t think I can identify them in advance. And if I can’t identify them in advance, it’s kind of pointless.

Gold: So, it’s all about predictive value, then, is what you’re saying.

Fama: Right. It’s all about predictive value, not hindsight value.

Gold: Hindsight’s 20/20 anyway.

Fama: It’s at least 20/20.

Gold: Are there inefficiencies within the market? For example, in the flash crash of 2014, the yield on 10-year Treasurys moved by 1.6% in 12 minutes. And last April, the crude oil price went down to minus $37 a barrel. How do wild price swings like that fit into your theory?

Fama: Perceptions are important when people act on them. If you were to look at, for example, GameStop, that’s a clear case where, for a couple of days, the market was inefficient.

You take a tiny stock and people start piling in. Well, finance is no different from any other branch of economics. It’s all supply and demand. If the demand goes crazy, the price can go crazy — temporarily.

Gold: So, does irrationality play a role in the market, not rationally driven behavior, which is what economists have usually assumed? Do you see pockets of irrationality within an efficient market?

Fama: The people who are piling into GameStop didn’t think they were irrational. Turns out, at least half of them probably lost everything. In that kind of game, when it goes up and comes back down, there are as many losers as there are winners.

Gold: So, what conclusions should we draw from these episodes?

Fama: No investor should play that game where you’re speculating in individual assets. Individual stocks or assets can be out of line for periods of time. You expect them to correct. It’s going to generate some big winners, perhaps, but it’s also going to generate big losers. And I’m not sure you can say which one you’ll be before the game starts. You can protect yourself from things like GameStop by holding a diversified portfolio.

Gold: You and your colleague at Chicago Booth, [Nobel Prize winner] Richard Thaler, have had some spirited discussions about behavioral finance, and again, your main objection to behavioral finance seems to be that it has no predictive value for stock prices.

Fama: What I say is, there is no such thing as behavioral finance. It’s just a criticism of efficient markets. What that says to me is I’m the most important person in behavioral finance, because without me, they have nothing to criticize. I have challenged him for the last 25 years or so, “tell me what the behavioral theory of pricing is.” He can’t do it. There is no such thing.

With respect to markets, what is it? Emotion is important? Big deal. Of course, it is. But what does it imply, empirically? What’s the prediction?

Gold: You don’t think it describes certain behavior in the market, or certain behavior of individuals acting in the market?

Fama: Maybe individuals, but not prices. You can throw out the exceptions, like GameStop. Some emotions were playing a big role in the crash, in those examples. But those are the exceptions, not the rule.

Gold: Did you also say you don’t believe in bubbles?

Fama: I believe in them if you can tell me when they are going to burst. But in my world, the definition of a bubble is something that has a predictable ending. If it’s just something you use to describe an up and a down, well, that has no context for me. Those things happen in random series.

Gold: Do you believe in manias or speculation? Would GameStop GME, +26.94% be one example?

Fama: For a couple of days, the market was very inefficient.

Gold: OK. And what about the housing bubble?

Fama: That one doesn’t work. Because the prices went up and they came down. But now they’re up higher than they were at the previous peak, so what’s the bubble? Is it the up and the down? Or is the down and the up?

Gold: Maybe it’s the up, when people put everything they have into it, and then it goes down, and they sell at the bottom?

Fama: Great, but then how’d it get back up again?

Gold: Other people come in.

A lot of the theories underlying modern finance were based mostly on periods where we had actual positive interest rates. We didn’t have a Federal Reserve that was keeping rates at zero and buying trillions of dollars in securities. A lot of the things we’re seeing now are things we have never seen before in the market.

Fama: That’s almost always true. In the early 1980s, interest rates were up around 20%, and so was inflation. The real rate wasn’t much different then than it is now. [The real rate is the interest rate adjusted for inflation.] But now we have exceptionally low inflation, for whatever reason. The real rate is not that far out, relative to historical numbers. But the real rate bounces around between plus or minus 2%. And it’s close to minus 2% now.

Gold: We have seen, over the last ten to 15 years, huge outperformance of growth over value stocks. Could this just be a period of real outperformance for this group, and could we see a reversion to the mean and value re-emerging?

Fama: It’s a possibility. But going back, who would predict Google GOOG, +1.41% or Amazon AMZN, +3.76% being the giants of today? You surely remember the dot-com bubble, or what people call a bubble, but out of that came these companies. Only a few of them really made it big, but they’re huge by any historical comparison. If you look at the 50 biggest stocks at any point in time, look 20 years, 30 years later, almost none of those stocks will still be in that group.

Gold: So, is the best strategy for investors to buy low-cost index funds that capture the efficiencies in the market and mute the inefficiencies?

Fama: That’s a good way to put it. And then the big problem is deciding how you want to split between short-term bonds — I wouldn’t recommend long-term bonds for any individual investors — versus stocks. How much risk do you want to take?

Gold: People always come up to me and ask me for stock tips. And I tell them, “Buy an index fund.” They look so disappointed.

Fama: Everybody wants a free lunch, right?

Gold: They think I have some inside knowledge, being a columnist for MarketWatch. Nobody gives me these tips anyway.

Fama: They’d go to jail.