Eugene Fama is the Susan Lucci of the Nobel Prize world. He not only developed the Efficient Markets Hypothesis, which sits beneath almost every theory in finance, but he also is on faculty at the University of Chicago, a Nobel factory. Still, Fama has not received the early-morning call from Sweden. That’s too bad. The Efficient Markets Hypothesis says that market prices are accurate because everyone has the information needed to make rational investment decisions. In the real world, markets are not perfectly efficient, but they are close. The Efficient Markets Hypothesis assumption helps people try to figure out where the flaws are. (It goes without saying that those people who believe that markets are always efficient do not see the flaws and make mistakes. Fama, by the way, does not think markets are perfectly efficient.)

The Efficient Markets Hypothesis doesn’t assume that everyone involved is wise, but that there are more people with good information than bad information. The signal-to-noise ratio is high enough that the irrational and uninformed traders cancel each other out. Over the long run, this seems to be true, but there can be enormous deviations from efficiency in the short term as traders figure out who has the right information. (more…)