An essay by Eugene F. Fama
- April 07, 2014
- CBR - Finance
An essay by Eugene F. Fama
I first came to the business school at Chicago as a student in 1960. Before then, I was a student at Tufts. For my first two years, I was majoring in Romance languages with the idea that I would become a high school teacher and a sports coach. In my third year, I started to get a little bit bored with talking about Voltaire every other day, so I took an economics course, loved it, and did pretty well at it. I spent my last two years studying economics.
When it came time to graduate from Tufts, I decided I didn’t want to work for a living. I figured I would go on to get a graduate degree, and business schools were my choice.
I went to my economics professors and said, “Where should I go?”
They said, “Well, you eventually want to get a PhD; you should go to Chicago because it’s more academically oriented than Harvard.”
I applied to Harvard, and I applied to Chicago. I got into Harvard, but I never heard from Chicago.
In the middle of April, I called the Dean of Students’ office, and the dean of students himself answered. It was Jeff Metcalf, who served in that position for two decades. He and his secretary were the only two people in that office. That’s how small the school was.
He looked and said, “Gee, we have no record of your application.”
I said, “Well, I did send it.”
Jeff was a very amiable fellow. We were chatting, and he said, “What are your grades like?”
I said, “They’re pretty good.”
He said, “We just happen to have a scholarship for somebody from Tufts. Do you want it?” And that’s how I came to Chicago.
So it was serendipity that I was admitted as an MBA student. When I arrived, I went to the PhD office, and talked to Joel Segal, who was the director of the program at the time. I said, “I think I want to go into the PhD Program.”
He said, “You better do a quarter as an MBA because graduate school is a lot different than undergraduate school. See how you do, and we’ll judge you after that.”
I went back to him at the end of the quarter and I said, “You were right. graduate school is a lot different from undergraduate school—it’s a lot easier.”
Business schools were much weaker then. There were a couple hundred students at Chicago at the time, and the level wasn’t that great. The top of the class was very good; the bottom was not good, and the quality of the program was bad. This was not the case only at Chicago, mind you—all business schools were bad.
Finance was a joke. There were courses in security analysis, which we don’t give any more; capital budgeting, which is done in a week or so now; and money and banking, which is now done by the macro group. I took most of my courses in the economics department.
I said earlier that getting into Chicago, talking to Jeff Metcalf, was serendipity. When it came time to write a thesis, I hit on a second piece of serendipity.
I happened to be writing my thesis at a propitious time, right when computers were introduced. They liberated statisticians to do things they couldn’t do before. They started digging into data.
What’s the easiest data to get? Stock prices, which is why lots of statisticians and economists started working on stock prices. As economists got into it, they started to ask, “How would we expect prices to behave if markets were working properly?” And that was how the efficient markets hypothesis, the hypothesis that prices reflect all available information, had its birth.
Let me tell you a bit about the evolution of finance. Finance has its birth in 1952 with the PhD thesis of Harry Markowitz on portfolio theory that he did in the Department of Economics. Harry got the Nobel Prize in 1990. Rumor has it that at the time he wrote his thesis, the people in the department said, “This is nothing.” That’s how perspicacious they were.
Franco Modigliani and Merton Miller came along in 1958, with a theory that formed the basic foundations of corporate finance, the proposition that financing decisions really don’t affect the market values of companies. And then in 1963, 1964, Bill Sharpe and John Lintner came out with the capital asset pricing model, which was the first model for describing how risks should be measured and what the equilibrium relation between risk and expected return should be.
This really enlightened the work on efficient markets. It dawned on me that the reason we’d been fumbling around with the concept was we hadn’t really been facing the issue. You can’t say whether prices reflect all available information unless you say something about what the market is trying to do in setting prices. And that’s what a model of market equilibrium is all about. So I wrote a paper in 1970 that laid all of this out, and it was basically the first complete statement of market efficiency.
In 1972, 1973, Robert Merton, Myron Scholes, and Fischer Black came out with the options pricing model. The Black-Scholes paper is, in my view, the most important paper in economics of the 20th century. No other paper has to be learned by every single economist getting a PhD and has also created an industry—the derivatives industry.
Next, Bob Merton generalized the risk-return story to more complicated scenarios. And in 1978, Bob Lucas, the John Dewey Distinguished Service Professor in Economics and the College, came up with the consumption based asset pricing model.
A good part of what we’ve done in finance had its birth at that time: portfolio theory, the first models of market equilibrium, and then efficient markets. Much of the work since then is a development of these basic paradigms. There has been a mountain of empirical work. It permeates the MBA and PhD curricula. The courses now look nothing like they did then. In 1963, there were no good journals in finance. Now, there are probably five that are as good as any of the journals in economics, and another five that are better than anything we had. Then, there were only three serious finance groups in the world: Chicago, MIT, and Carnegie Mellon. Now, every major university has a well-functioning finance faculty doing first-rate research.
And that was another piece of serendipity. I came along when everything you did was new. Now, when PhD students want to work on a topic, they can be sure that somebody—probably 20 other people—have already done something, and they have to go through all of that. It was much easier to be a young researcher in those days than it is now.
I love my work. I have no intention of stopping as long as I’m breathing—and I may even do it after that.
This is an edited version of the speech given by Eugene F. Fama, the Robert R. McCormick Distinguished Service Professor of Finance, at Chicago Booth’s Convocation ceremony on June 15, 2013.
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