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The Rational Stock Market Crash

Last update on: Feb 25 2020

One of the better interviews with Eugene Fama, promoter of the efficient market theory and co-winner of the 2013 Nobel Prize in Economics, recently was in Fortune. It does a good job of tracking Fama’s thinking and how it changed over the years. As Fama says, a lot of people misrepresent his work and think the financial crisis of 2008 invalidate it. Fama disagrees with that conclusion and also has modified his views over the years as new data and studies accumulate.

Nonsense, says Mr. Efficient Markets. The mere use of the term “bubble” makes Fama see red. He says asset price bubbles simply don’t exist. Fama argues that when stocks crash — as in the dotcom crash or the cataclysm of 2008 — it is caused by a perfectly logical fear that a depression might follow. Can there be such a thing as an efficient panic? Fama’s extreme view on the topic elicits disagreement from fans who think he’s mostly correct. “In my opinion, there’s no way that rational behavior caused the tech craze of 2000,” insists Cliff Asness, a former Fama student and co-founder of AQR Capital, a $90 billion asset-management firm. “It was a bubble, pure and simple.”

What everyone can take away from Fama’s work is that markets are mostly efficient, though maybe not as nearly perfect as Fama insists. And by spending a career documenting how these powerful processors of information are far more right than wrong, Fama has perhaps done more for individual investors than any other economist of the past half-century. “The efficient-market hypothesis is the North Star for everything in finance,” says Asness. “One of the implications of his research is that every manager must be measured against a passive index to show if they’re really successful, and almost all fail over time.”

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