Wednesday, January 3, 2018

Cochrane & Moskowitz, eds. The Fama Portfolio

I’m going to start 2018 on a high note, with The Fama Portfolio: Selected Papers of Eugene F. Fama (University of Chicago Press, 2017), edited by John H. Cochrane and Tobias J. Moskowitz. The subtitle is a tad misleading because, although this volume, over 800 pages in length, contains 20 papers that Fama either authored or co-authored, it also includes papers and commentaries by colleagues and former students.

Eugene Fama is best known, of course, for the efficient market hypothesis—that, as he succinctly described its strong version, “security prices fully reflect all available information.” But since a precondition for this version of the hypothesis is that there are no information and trading costs, it is, he readily admitted in his second paper on the EMH, “surely false. Its advantage, however, is that it is a clean benchmark that allows me to sidestep the messy problem of deciding what are reasonable information and trading costs. I can focus instead on the more interesting task of laying out the evidence on the adjustment of prices to various kinds of information. Each reader is then free to judge the scenarios where market efficiency is a good approximation (that is, deviations from the extreme version of the efficiency hypothesis are within information and trading costs) and those where some other model is a better simplifying view of the world.”

I quote this passage because I believe it illustrates Fama’s dedication to empiricism. He was no “so much the worse for the facts” theorist. As Kenneth French wrote in “Things I’ve Learned from Gene Fama,” “Gene is arguably the best empiricist in finance.”

In addition to his papers on efficient markets, which includes one he coauthored with French on “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” this volume contains papers on risk and return, return forecasts and time-varying risk premiums, and corporate finance and banking. Especially notable are the Fama and French papers on “Common Risk Factors in the Returns on Stocks and Bonds” and “Multifactor Explanations of Asset Pricing Anomalies.”

As long as the reader has a basic grasp of statistical principles, Fama’s papers are eminently comprehensible. And, despite all the criticism of the EMH, they should still be studied with care, both as case studies in how to do first-rate financial research and for the insights they provide into financial markets. I laud the editors for gathering such important work into a single volume. It’s a book every student of finance and financial professional should have in his library.

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