Back in those days - we are talking the early 1960s - Mr Fama was a student needing extra money, so he worked for a college professor in Boston, Massachusetts, who ran a tip sheet based on finding momentum plays. Mr Fama could help out because he was one of the few students who knew how to use a computer. He back-tested for momentum stock picks and spotted lots of good ideas, then - and this is what aroused his curiosity - he found that, when real money was riding on those picks, all too often their performance was disappointing. Why was that?
The answer was - and is - because at any point in time securities prices in big, liquid markets will take account of all known information and interpretations thereof. So only new information or assessments would shift the price, and from where and when that would emerge is impossible to say. To use the jargon, prices are 'efficient'; as a result, their changes follow an unpredictable 'random walk'.
The efficient market hypothesis and its precursor, random walk theory, are enduringly fascinating because they can seem so outlandish - comical even - to non-economists. They reduce to the parody of five-year-olds picking portfolios by throwing darts at the Financial Times 'Share Service' pages and producing returns that beat some professionals. How can that be anything but comical? Yet simultaneously, the idea of efficient prices is so obvious to economists that it prompted another Nobel Prize winner, William Sharpe, to call it "almost trivially self evident . . . so much so that testing seems rather silly".
For years the academic economists - presumably because they are clever, though not without self interest - got the upper hand and the efficient market hypothesis became an undisputed truth in the developed world's central banks. The collapse of Lehman Brothers and what followed put paid to all that and the new conventional wisdom is that the hypothesis is as loony as many financial analysts had said all along. So how come Mr Fama was awarded a Nobel Prize last week and - more curious still - alongside Robert Shiller, whose best-known work shows that financial markets are often driven by sustained bouts of irrationality?
Because the truth of the efficient market hypothesis is undiminished by what has happened since 2008. It continues to offer investors a vital insight into how markets behave and how they should respond. Put it this way - to believe that big, liquid financial markets are anything other than efficient is the equivalent of believing the world is flat or that it was created in six days.
True, some of the intellectual roots of the hypothesis are in discredited bits of classical economics which assume that rational, profit-maximising players shape markets; that said, no one should imagine that when players act irrationally they are no longer profit-seeking. However, the hypothesis continues to give us a useful model of how financial markets work because it tells us that:
■ Markets are efficient because no one can be certain in which direction a security's price will move next, or the move after that, or the one after and so on.
■ From that, it follows that markets are efficient because no one can consistently say that a security's price is wrong and profit from it.
■ Prices can look wrong - they can look hideously wrong - but no one can act on that, however good their analysis, and expect to make excess returns over the long haul. Even those few who achieve consistent excess returns cannot know before the fact that they are going to make them.
This distils into the following: markets are efficient because we can never consistently say that a price is right or wrong. And this is completely consistent with the idea that prices can be irrational. After all, if we can never say whether a price is wrong, how can we say if it is at irrational levels. And from that, how can we know if a market is being driven by rationality or irrationality?
This is the bind that central bankers got themselves into (and which the world's investment bankers exploited ruthlessly). If you can't say that prices are irrational, then you can't say that there is an asset price bubble, they argued. And if you can't say there is an asset price bubble, then there is no bubble to burst.
The central bankers were consistent with their intellectual reasoning. They were less consistent in practice. While they never felt justified in bursting a bubble in the financial markets, they were quite willing to institute the interest rate cuts needed in order to stop a bubble that may or may not have existed from bursting.
Whether Mr Fama and the efficient market hypothesis can be blamed for that is doubtful. Besides, for the purposes of this column, it's irrelevant. What we investors have to grasp from it is this: seek excess returns though we may, we should not pretend that we know where prices are going. Do that and we just deceive ourselves.
