Two Pillars of Asset Pricing

Prize Lecture, December 8, 2013

by Eugene F. Fama
Booth School, University of Chicago, Chicago, IL, USA.

he Nobel Foundation asks that the Prize lecture cover the work for which
the Prize is awarded. The announcement of this years Prize cites empirical
work in asset pricing. I interpret this to include work on efficient capital markets
and work on developing and testing asset pricing modelsthe two pillars, or
perhaps more descriptive, the Siamese twins of asset pricing. I start with efficient markets and then move on to asset pricing models.
Efficient Capital Markets

A. Early Work
The year 1962 was a propitious time for Ph.D. research at the University of Chicago. Computers were coming into their own, liberating econometricians from
their mechanical calculators. It became possible to process large amounts of data
quickly, at least by previous standards. Stock prices are among the most accessible data, and there was burgeoning interest in studying the behavior of stock
returns, centered at the University of Chicago (Merton Miller, Harry Roberts,
Lester Telser, and Benoit Mandelbrot as a frequent visitor) and MIT (Sidney
Alexander, Paul Cootner, Franco Modigliani, and Paul Samuelson). Modigliani often visited Chicago to work with his longtime coauthor Merton Miller, so
there was frequent exchange of ideas between the two schools.
It was clear from the beginning that the central question is whether asset
prices reflect all available informationwhat I labeled the efficient markets hypothesis (Fama 1965b). The difficulty is making the hypothesis testable. We cant
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test whether the market does what it is supposed to do unless we specify what
it is supposed to do. In other words, we need an asset pricing model, a model
that specifies the characteristics of rational expected asset returns in a market
equilibrium. Tests of efficiency basically test whether the properties of expected
returns implied by the assumed model of market equilibrium are observed in
actual returns. If the tests reject, we dont know whether the problem is an inefficient market or a bad model of market equilibrium. This is the joint hypothesis
problem emphasized in Fama (1970).
A bit of notation makes the point precise. Suppose time is discreet, and Pt+1
is the vector of payoffs at time t + 1 (prices plus dividends and interest payments) on the assets available at t. Suppose f(Pt+1tm) is the joint distribution
of asset payoffs at t + 1 implied by the time t information set tm used in the
market to set Pt, the vector of equilibrium prices for assets at time t. Finally, suppose f(Pt+1t) is the distribution of payoffs implied by all information available
at t, t; or more pertinently, f(Pt+1t) is the distribution from which prices at
t + 1 will be drawn. The market efficiency hypothesis that prices at t reflect all
available information is,
(1)

f(Pt+1tm) = f(Pt+1t).

The market efficiency condition is more typically stated in terms of expected

returns. If E(Rt+1tm) is the vector of expected returns implied by f(Pt+1tm)
and the equilibrium prices Pt, and E(Rt+1t) is the expected return vector implied by time t prices and f(Pt+1t), the market efficiency condition is,
(2)

E(Rt+1tm) = E(Rt+1t),

The prices observed at t + 1 are drawn from f(Pt+1t), so in this sense

f(Pt+1t) and E(Rt+1t) are observable, but we do not observe f(Pt+1tm)
and E(Rt+1tm). As a result, the market efficiency conditions (1) and (2) are
not testable. To have testable propositions, we must specify how equilibrium
prices at t relate to the characteristics of f(Pt+1tm). In other words, we need
a model of market equilibriuman asset pricing model, no matter how primitivethat specifies the characteristics of rational equilibrium expected returns,
E(Rt+1tm).
For example, in many early tests, market efficiency is assumed to imply that
returns are unpredictable based on past information. The implicit model of
market equilibrium is that equilibrium expected returns are constant,
(3)

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E(Rt+1tm) = E(R).

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If the market is efficient so that (2) holds, then
(4)

E(Rt+1t) = E(R).

The testable implication of (4) is that a regression of Rt+1 on variables from t,

which are known at time t, should produce slopes that are indistinguishable
from zero. If the test fails, we dont know whether the problem is a bad model
of market equilibrium (equation (3) is the culprit) or an inefficient market that
overlooks information in setting prices (equations (1) and (2) do not hold). This
is the joint hypothesis problem.
The joint hypothesis problem is perhaps obvious in hindsight, and one can
argue that it is implicit in Bachelier (1900), Muth (1961), Samuelson (1965), and
Mandelbrot (1966). But its importance in work on market efficiency was not
recognized before Fama (1970), which brought it to the forefront.
For example, many early papers focus on autocorrelations and it was common to propose that market efficiency implies that the autocorrelations of returns are indistinguishable from zero. The implicit model of market equilibrium, never acknowledged in the tests, is (3), that is, the market is trying to price
stocks so that their expected returns are constant through time.
A clean statement of the joint hypothesis problem, close to that given above,
is in Chapter 5 of Fama (1976b). Everybody in finance claims to have read this
book, but given its sales, they must be sharing the same copy.
Market efficiency is always tested jointly with a model of market equilibrium, but the converse is also true. Common asset pricing models, like the capital asset pricing model (CAPM) of Sharpe (1964) and Lintner (1965), Mertons
(1973a) intertemporal CAPM (the ICAPM), and the consumption CAPM of
Lucas (1978) and Breeden (1979), implicitly or explicitly assume that all information is costlessly available to all market participants who use it correctly in
their portfolio decisionsa strong form of market efficiency. Thus, tests of these
asset pricing models jointly test market efficiency.

B. Event Studies
In the initial empirical work on market efficiency, the tests centered on predicting returns using past returns. Fama, Fisher, Jensen, and Roll (FFJR 1969) extend the tests to the adjustment of stock prices to announcements of corporate
events. In FFJR the event is stock splits, but the long-term impact of the paper
traces to the empirical approach it uses to aggregate the information about price
adjustment in a large sample of events.

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Like other corporate events, the sample of splits is spread over a long period
(19261960). To abstract from general market effects that can obscure a stocks
response to a split, we use a simple market model time series regression,
(5)

Rit = ai + biRMt + eit.

In this regression, Rit is the return on stock i for month t, RMt is the market
return, and the residual eit is the part of the securitys return that is not a response to the market return. The month t response of the return to a split is thus
embedded in eit. To aggregate the responses across the stocks that experience a
split, we use event time rather than calendar time. Specifically, t = 0 is the month
when information about a split becomes available, t = 1 is the previous month,
t = 1 is the following month, etc. Thus, period 0 is a different calendar month for
each split. To measure the average response of returns in the months preceding
and following a split, we average the residuals for the stocks in the sample for
each of the 30 months preceding and following the split. To measure the cumulative response, we sequentially sum the average residuals.
The results of the split paper are striking. The cumulative average residual
(Figure 1) rises in the months preceding a split. Thus, companies tend to split
their stocks after good times that produce large increases in their stock prices.
Once the split becomes known, however, there is no further movement in the
cumulative average residual, despite the fact that about 75% of the companies
that split their stocks continue to experience good times (witnessed by subsequent dividend growth rates larger than those of the market as a whole). In other
words, on average, all the implications of a split for the future performance of a
company are incorporated in stock prices in the months leading up to the split,
with no further reaction thereafterexactly the prediction of market efficiency.
The split paper spawned an event study industry. To this day, finance and accounting journals contain many studies of the response of stock prices to different corporate events, for example, earnings announcements, merger announcements, security issues, etc. Almost all use the simple methodology of the split
paper. Like the split study, other early event studies generally confirm that the
adjustment of stock prices to events is quick and complete.
Early event studies concentrate on short periods, typically days, around an
event. Over short periods the assumed model for equilibrium expected returns
is relatively unimportant because the change in the price of the stock in response
to the event is typically much larger than short horizon expected returns. In
other words, the joint hypothesis problem is relatively unimportant. More recently, researchers in behavioral finance became interested in studying price

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Figure 1. Cumulative average residuals in the months surrounding a split. Source: Fama,
Fisher, Jensen, and Roll (1969).

responses for several years after an event. Over such long periods, expected returns are larger relative to the price effect of the event, and the joint hypothesis
problem becomes important.
For example, the implicit model of market equilibrium in the split study is
that the regression intercept and slope, ai and bi, in the market model regression (5) are constant through time. It is now well-known that ai and bi change
through time. This can produce drift in long-term cumulative average regression residuals that looks like market inefficiency but is just a bad model for expected returns. These issues are discussed in Fama (1998).

C. Predictive Regressions
The early work on market efficiency focuses on stock returns. In Fama (1975), I
turn to bonds to study Irving Fishers (market efficiency) hypothesis that it+1, the
time t interest rate on a short-term bond that matures at t + 1, should contain
the equilibrium expected real return, E(rt+1), plus the best possible forecast of
the inflation rate, E(t+1),
(6)

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it+1 = E(rt+1) + E(t+1).

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The topic is not new, but my approach is novel. Earlier work uses regressions of
the interest rate on lagged inflation rates,
(7)

it+1 = a + b1t + b2t1 + ... + t+1.

The idea is that the expected inflation rate (along with the expected real
return) determines the interest rate, so the interest rate should be the dependent
variable and the expected inflation rate should be the independent variable. Past
inflation is a noisy measure of expected inflation, so equation (7) suffers from
an errors-in-variables problem. More important, in an efficient market the expected inflation rate built into the interest rate surely uses more information
than past inflation rates.
The insight in Fama (1975), applied by me and others in subsequent papers,
is that a regression estimates the conditional expected value of the left-handside variable as a function of the right-hand-side variables. Thus, to extract the
forecast of inflation in the interest rate (the expected value of inflation priced
into the interest rate), one regresses the inflation rate for period t + 1 on the
interest rate for t + 1 set at the beginning of the period,
(8)

t+1 = a + bit+1 + t+1.

The expected inflation rate estimated in this way captures all the information used to set the interest rate. In hindsight, this is the obvious way to run the
forecasting regression, but it was not obvious at the time.
Reversing the regression eliminates one measurement error problem, but
it can introduce another, caused by variation through time in the expected real
return built into the interest rate. The model of market equilibrium in Fama
(1975) is that the expected real return is constant, E(rt+1) = r. Near zero autocorrelations of real returns suggest that this proposition is a reasonable approximation, at least for the 19531971 period examined. Thus, at least for this period,
the interest rate it+1 is a direct proxy for the expected inflation rateit is the
expected inflation rate plus a constant.
The slopes in the estimates of (8) for the one-month, three-month, and sixmonth U.S. Treasury Bill rates and inflation rates of 19531971 are quite close
to 1.0, and the autocorrelations of the residuals are close to zero. Thus, the bottom line from Fama (1975) is that interest rates on one-month, three-month,
and six-month Treasury Bills seem to contain rational forecasts of inflation one,
three, and six months ahead.
Fishers hypothesis that expected asset returns should include compensation
for expected inflation applies to all assets. Fama and Schwert (1977) test it on

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longer term bonds, real estate, and stock returns. The proposed model of market
equilibrium has two parts. First, as in Fama (1975), the equilibrium expected
real returns on bills are assumed to be constant through time, so the bill rate can
again be used as the proxy for the expected inflation rate. Second, any variation
in equilibrium expected real returns on other assets is assumed to be uncorrelated with expected inflation. With this model of market equilibrium, we can
test Fishers hypothesis with regressions of the nominal return on an asset, Rt+1,
on the bill rate set at the beginning of period t + 1,
(9)

Rt+1 = a + bit+1 + t+1.

The tests say that monthly, quarterly, and semi-annual nominal returns on
longer-term bonds and real estate compensate for monthly, quarterly, and semiannual expected inflation: that is, for these assets the slopes in the estimates of
(9) are again near 1.0. Thus, we cannot reject the market efficiency proposition
that bond and real estate prices incorporate the best possible forecasts of inflation and the model of market equilibrium in which expected real returns vary
independently of expected inflation.
The relation between common stock returns and expected inflation, however, is perverse. The slopes in the estimates (9) for stocks are negative; expected
stock returns are higher when expected inflation (proxied by the bill rate) is
low and vice versa. Thus for stocks we face the joint hypothesis problem. Do
the tests fail because of poor inflation forecasts (market inefficiency) or because
equilibrium expected real stock returns are in fact negatively related to expected
inflation (so we chose a bad model of market equilibrium)?
The simple idea about forecasting regressions in Fama (1975)that the
regression of a return on predetermined variables produces estimates of the
variation in the expected value of the return conditional on the forecasting variableshas served me well. I have used it in a sequence of papers to address an
old issue in the term structure literature, specifically, how well do the forward
interest rates that can be extracted from prices of longer-term discount bonds
forecast future one-period (spot) interest rates (Fama 1976a,c, 1984b,c, 1986,
1990a, 2005, and Fama and Bliss 1987).
To see the common insight in these term structure papers, define the term
(or maturity) premium in the one-period return on a discount bond with T
periods to maturity at time t as the difference between the return, RTt+1, and
the one-period spot interest rate observed at time t, St+1. Skipping the tedious
details, it is easy to show that the time t forward rate for period t + T, Ft,t+T, contains the expected term premium, E(RTt+1) St+1, as well as a forecast of the spot

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rate for t + T, E(St+T). As a result, there is a pair of complementary regressions

that use the difference between the forward rate and the current spot rate to
forecast the term premium and the future change in the spot rate,
(10)

RTt+1 St+1 = a1 + b1(Ft,t+T St+1) + e1,t+1

(11)

St+T St+1 = a2 + b2(Ft,t+T St+1) + e2,t+T

The conclusion from this work is that the information in forward rates is
primarily about expected term premiums rather than future spot rates; that is,
the slope in (10) is near 1.0, and the slope in (11) is near 0.0. There is, however,
some longer-term predictability of spot rates due to mean reversion of the spot
rate (Fama and Bliss 1987), though not necessarily to a constant mean (Fama
2005).
In Fama (1984a), I apply the complementary regression approach to study
forward foreign exchange rates as predictors of future spot rates. Again, the
information in forward exchange rates seems to be about risk premiums, and
there is little or no information about future spot exchange rates. The exchange
rate literature has puzzled over this result for 30 years. Using the complementary
regression approach, Fama and French (1987) find that futures prices for a wide
range of commodities do show power to forecast spot pricesthe exception to
the general rule.

D. Time Varying Expected Stock Returns

As noted above, early work on market efficiency generally assumes that equilibrium expected stock returns are constant through time. This is unlikely to be
true. The expected return on a stock contains compensation for bearing the risk
of the return. Both the risk and the willingness of investors to bear the risk are
likely to change over time, leading to a time-varying expected return. The trick
is to find predetermined variables that can be used to track expected returns in
forecasting regressions.
Fama and Schwert (1977) document variation in monthly, quarterly, and
semi-annual expected stock returns using predetermined monthly, quarterly,
and semi-annual Treasury bill rates. In later work, the popular forecasting variable on the right hand side of the regression is the dividend yield, the ratio of
trailing annual dividends to the stock price at the beginning of the forecast period. The motivation, which I attribute to Ball (1978), is that a stocks price is
the present value of the stream of expected future dividends, where the discount

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rate is (approximately) the expected stock return. Thus, a high stock price relative to dividends likely signals a lower expected return, and vice versa. The word
likely is needed because price also depends on expected future dividends,
which means the dividend yield is a noisy proxy for the expected stock return,
a problem emphasized by Campbell and Shiller (1988) and others. Cochrane
(2010) gives an elegant explanation of the problem in terms of complementary
regressions that use the dividend yield to forecast long-term average stock returns and long-term dividend growth.
To my knowledge, the first papers that use dividend yields to track expected
stock returns are Rozeff (1984) and Shiller (1984). Fama and French (1987) add
an interesting wrinkle to the evidence. We find that the explanatory power of
the regression, measured by the regression R2, increases as the horizon for the
return is extended in steps from a month to four years. This result may seem
surprising, but it is just a consequence of the fact that dividend yields are persistent (highly autocorrelated).
For example, with persistent dividend yields, the slope in the regression of
the quarterly stock return on the beginning of quarter yield will be about three
times the slope in the regression of the monthly return on the beginning of
month yield. Thus, the variance of the expected return estimate in the threemonth regression is about nine times the variance in the one-month regression.
But the variance of the residual in the three-month regression (the unexpected
part of the return) is only about three times the variance of the residual in the
one-month regression. As a result, R2 is higher in the three-month regression.
Higher R2 for longer return horizons due to the persistence of the dividend
yield implies that the variance of the predictable part of returns rises faster than
the variance of the unpredictable part, so in this sense longer horizon returns are
more predictable. But unpredictable variation in returns also rises with the return
horizon, that is, the variance of forecast errors is larger in longer-term returns, so
in this more important sense, longer horizon returns are less predictable.
Efficient market types (like me) judge that predictable variation in expected
returns on stocks and bonds is rational, the result of variation in risk or willingness to bear risk. In contrast, behaviorists argue that much of the predictability
is due to irrational swings of prices away from fundamental values.
Fama and French (1989) address this issue. They find that the well-known
variation in expected bond returns tracked by two term structure variables, (i)
the default spread (the difference between the yields on long-term bonds of high
and low credit risk) and (ii) the term spread (the difference between long-term
and short-term yields on high grade bonds) is shared with stock returns. Likewise, dividend yields predict bond returns as well as stock returns. Moreover,

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default spreads and dividend yields are related to long-term business conditions,
and term spreads are strongly related to short-term business cycles. The general
result is that expected returns are high when business conditions are poor and
low when they are strong.
The evidence that the variation in expected returns is common to stocks
and bonds and related to business conditions leads Fama and French (1989) to
conclude that the resulting predictability of stock and bond returns is rational.
Behaviorists can disagree. Animal spirits can roam across markets in a way that
is related to business conditions. No available empirical evidence resolves this
issue in a way that convinces both sides.
Shiller (1981) finds that the volatility of stock prices is much higher than can
be explained by the uncertain evolution of expected future dividends. This result
implies that much of the volatility of stock prices comes from time-varying expected returns. The market efficiency issue is whether the variation in expected
returns necessary to explain Shillers results is beyond explanation by a model
for rational expected returns. It is certainly possible to develop models for expected returns that produce this conclusion in empirical tests. But then we face
the joint hypothesis problem. Do the tests fail because the market is inefficient
or because we have the wrong model for rational expected returns? This and
other market efficiency issues are discussed in detail in Fama (1991).

E. Bubbles
There is one remaining result in the literature on return predictability that warrants mention. The available evidence says that stock returns are somewhat
predictable from dividend yields and interest rates, but there is no statistically
reliable evidence that expected stock returns are sometimes negative. Fama and
French (1987) find that predictions from dividend yields of negative returns for
market portfolios of U.S stocks are never more than two standard errors below
zero. Fama and Schwert (1977) find no evidence of reliable predictions of negative market returns when the forecast variable is the short-term bill rate.
These results are important. The stock market run-up to 2007 and subsequent decline is often called a bubble. Indeed, the word bubble, applied to
many markets, is now common among academics and practitioners. A common
policy prescription is that the Fed and other regulators should lean against asset
market bubbles to preempt the negative effects of bursting bubbles on economic
activity.
Such policy statements seem to define a bubble as an irrational strong
price increase that implies a predictable strong decline. This also seems to be

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the definition implicit in most recent claims about bubbles. But the available
research provides no reliable evidence that stock market price declines are ever
predictable. Thus, at least as the literature now stands, confident statements
about bubbles and what should be done about them are based on beliefs, not
reliable evidence.
Reliable is important in this discussion. After an event, attention tends
to focus on people who predicted it. The ex post selection bias is obvious. To
infer reliability for a particular forecaster, we need to evaluate his or her track
record of forecasts of different events, and for a particular event, we must evaluate the initial predictions of all forecasters we might have chosen ex ante. More
important, for the purposes of science and policy, we are interested in the performance of forecasting models, not the unreproducible predictions of specific
individuals.
The absence of evidence that stock market price declines are predictable
seems sufficient to caution that bubble is a treacherous term, but there is more.
Figure 2 shows the December 1925 to September 2013 path of the natural log
of U.S. stock market wealth, including reinvested dividends, constructed using
the value-weight market portfolio of NYSE, AMEX, and NASDAQ stocks from
the Center for Research in Security Prices (CRSP) of the University of Chicago.
The recessions identified by the NBER are shown as shaded areas on the graph.

Figure 2.Log of cumulative value of the CRSP market index, including dividends.
Shaded areas are U.S. recessions identified by the National Bureau of Economic Research
(NBER).

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In percent terms, and noting that these are end-of-month data, the largest
five price declines in Figure 2 are (1) August 1929 to June 1932, (2) October 2007
to February 2009, (3) February 1937 to March 1938, (4) August 2000 to September 2002, and (5) August 1972 to December 1974. All these price declines are
preceded by strong price increases, so these are prime bubble candidates.
These five periods are associated with recessions, and except for August
2000 to September 2002, the magnitude of the price decline seems to reflect the
severity of the recession. The peak of the market in 1929 is the business cycle
peak, but for the other four episodes, the market peak precedes the business
cycle peak. Except for August 2000 to September 2002, the market low precedes
the end of the recession. This pattern in stock prices also tends to occur around
less severe recessions.
It thus seems that large swings in stock prices are responses to large swings
in real activity, with stock prices forecasting real activitya phenomenon studied in detail in Fama (1981, 1990b). All this is consistent with an efficient market
in which the term bubble, at least as commonly used, has no content.
One might assert from Figure 2 that major stock market swings cause recessions and market upturns bring them to an end. (One can also assert that
the weatherman causes the weathera quip stolen from John Cochrane.) At
a minimum, however, (i) the absence of evidence that price declines are ever
predictable, and (ii) the evidence that the prime bubble candidates seem to be
associated with rather impressive market forecasts of real activity are sufficient
to caution against use of the bubble word without more careful definition and
empirical validation.
Common bubble rhetoric says that the declines in prices that terminate
bubbles are market corrections of irrational price increases. Figure 2 shows,
however, that major stock price declines are followed rather quickly by price
increases that wipe out, in whole or in large part, the preceding price decline.
Bubble stories thus face a legitimate question: which leg of a bubble is irrational, the up or the down? Do we see irrational optimism in the price increase
corrected in the subsequent decline? Or do we see irrational pessimism in the
price decline, quickly reversed? Or both? Or perhaps neither?
Finally, it is difficult to evaluate expert forecasts of bubbles in asset prices
since we tend to hear only success stories identified after the fact, and for a
particular bubble, we rarely know the all-important date of an experts first
forecast that prices are irrationally high. For a bit of fun, however, we can examine two commonly cited success stories.
On the website for his book, Irrational Exuberance, Shiller says that at a December 3, 1996 lunch, he warned Fed chairman Alan Greenspan that the level of

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stock prices was irrationally high. Greenspans famous Irrational Exuberance
speech followed two days later. How good was Shillers forecast? On December
3, 1996 the CRSP index of U.S. stock market wealth stood at 1518. It more than
doubled to 3191 on September 1, 2000, and then fell. This is the basis for the
inference that the original bubble prediction was correct. At its low on March
11, 2003, however, the index, at 1739, was about 15% above 1518, its value on
the initial bubble forecast date. These index numbers include reinvested dividends, which seem relevant for investor evaluations of bubble forecasts. If one
ignores dividends and focuses on prices alone, the CRSP price index on March
11, 2003 was also above its December 3, 1996 value (648 versus 618). In short,
there is not much evidence that prices were irrationally high at the time of the
1996 forecast, unless they have been irrationally high ever since.
The second success story is the forecast in the mid-2000s that real estate
prices were irrationally high. Many academics and practitioners made the same
forecast, but an easy one to date is Case and Shiller (2003), which was probably
written in late 2002 or early 2003. To give their prediction a good shot, I choose
July 2003 as the date of the first forecast of a real estate bubble. The S&P/
Case Shiller 20-City Home Price Index is 142.99 in July 2003, its peak is 206.52
in July 2006, and its subsequent low is 134.07 in March 2012. Thus, the price
decline from what I take to be the first forecast date is only 6.7%. The value to
homeowners from housing services during the almost nine years from July 2003
to March 2012 surely exceeds 6.7% of July 2003 home values. Moreover, on the
last sample date, October 2013, the real estate index, at 165.91, is 16% above its
value on the initial bubble forecast date. Again, there is not much evidence
that prices were irrationally high at the time of the initial forecast.
I single out Shiller and Case and Shiller (2003) only because their initial
forecasts of these two bubbles are relatively easy to date. Many academics, including (alas) some of my colleagues, made the same bubble claims at similar
times, or earlier.

F. Behavioral Finance
I conclude this section on market efficiency with a complaint voiced in my review of behavioral finance 15 years ago (Fama 1998). The behavioral finance
literature is largely an attack on market efficiency. The best of the behaviorists
(like my colleague Richard Thaler) base their attacks and their readings of the
empirical record on findings about human behavior in psychology. Many others
dont bother. They scour databases of asset returns for anomalies (a statistically
treacherous procedure), and declare victory for behavioral finance when they

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find a candidate. Most important, the behavioral literature has not put forth a full
blown model for prices and returns that can be tested and potentially rejected
the acid test for any model proposed as a replacement for another model.
Asset Pricing Models
This years Nobel award cites empirical research in asset pricing. Tests of market
efficiency are one branch of this research. The other is tests of asset pricing models, that is, models that specify the nature of asset risks and the relation between
expected return and risk. Much of my work is concerned with developing and
testing asset pricing models, the flip side of the joint hypothesis problem.

A. Fama and MacBeth (1973)

The first formal model of market equilibrium is the CAPM (capital asset pricing
model) of Sharpe (1964) and Lintner (1965). In this model market , the slope
in the regression of an assets return on the market return, is the only relevant
measure of an assets risk, and the cross-section of expected asset returns depends only on the cross-section of asset s.
In the early literature, the common approach to test this prediction was
cross-section regressions of average security or portfolio returns on estimates
of their s and other variables. Black, Jensen and Scholes (1972) criticize this
approach because it produces estimates of the slope for (the premium in expected returns per unit of ) that seem too precise, given the high volatility of
market returns. They rightly suspect that the problem is cross-correlation of the
residuals in the regression, which leads to underestimated standard errors. They
propose a complicated portfolio approach to solve this problem.
Fama and MacBeth (1973) provide a simple solution to the cross-correlation
problem. Instead of regressing average asset returns on s and other variables,
one does the regression period-by-period, where the period is usually a month.
The slopes in the regression are monthly portfolio returns whose average values
can be used to test the CAPM predictions that the expected premium is positive and other variables add nothing to the explanation of the cross-section of
expected returns. (This is best explained in chapter 9 of Fama 1976b).
An example is helpful. Fama and French (1992) estimate month-by-month
regressions of the cross-section of individual stock returns for month t, Rit, on
estimates bi of their s, their (logged) market capitalizations at the beginning of
month t, MCi,t1, and their book-to-market equity ratios, BMi,t1,
(12)

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Rit = at + a1tbi + a2tMCi,t1 + a3tBMi,t1 + eit.

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Two Pillars of Asset Pricing379

In the CAPM the cross-section of expected returns is completely described
by the cross-section of s, so MCi,t1, and BMi,t1 should add nothing to the explanation of expected returns. The average values of the slopes a2t, and a3t for
MCi,t1, and BMi,t1 test this prediction, and the average value of the slope a1t for
bi tests the CAPM prediction that the premium for is positive.
The key to the test is the simple insight that the month-by-month variation
in the regression slopes (which is, in effect, repeated sampling of the slopes)
captures all the effects of the cross-correlation of the regression residuals (and
of multicollinearity of the explanatory variables). The time-series standard errors used to calculate t-statistics for the average slopes thus capture the effects
of residual covariance without requiring an estimate of the residual covariance
matrix. And inferences lean on the relatively robust statistical properties of t
tests for sample means.
The Fama-MacBeth approach is standard in tests of asset pricing models
that use cross-section regressions, but its benefits carry over to panels (time series of cross-sections) of all sorts. For example, Kenneth French and I use the approach to examine issues in corporate finance (Fama and French 1998, 2002). In
applications in which the dependent variable in the regression is asset returns,
autocorrelation of the period-by-period regression slopes (which are portfolio
returns) is not a problem. When autocorrelation of the slopes is a problem, as is
more likely in other applications, correcting the standard errors of the average
slopes is straightforward.
Outside of finance, research in economics that uses panel regressions has
slowly come to acknowledge that residual covariance and autocorrelation are
pervasive problems. Robust regression clustering techniques are now available (for example, Thompson 2011). The Fama-MacBeth approach is a simple
alternative.

B. The Problems of the CAPM

The evidence in Black, Jensen, and Scholes (1972) and Fama and MacBeth
(1973) is generally favorable to the CAPM, or at least to Blacks (1972) version
of the CAPM in which there is no risk-free security. The golden age of the model
is, however, brief. In the 1980s, violations, labeled anomalies, begin to surface.
Banz (1981) finds that market does not fully explain the higher average returns of small (low market capitalization) stocks. Basu (1983) finds that the
positive relation between the earning-price ratio (E/P) and average return is left
unexplained by . Rosenberg, Reid, and Lanstein (1985) find a positive relation
between average stock return and the book-to-market equity ratio (B/M) that

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is missed by the CAPM. Bhandari (1988) documents a similar result for market
leverage (the ratio of debt to the market value of equity, D/M). As noted earlier,
Ball (1978) argues that variables like size, E/P, B/M, and D/M are natural candidates to expose the failures of asset pricing models as explanations of expected
returns since all these variables use the stock price, which, given expected dividends, is inversely related to the expected stock return.
Viewed one at a time in the papers that discovered them, the CAPM anomalies seemed like curiosity items that show that the CAPM is just a model and
cant be expected to explain the entire cross-section of expected stock returns.
In updated tests, Fama and French (1992) examine all the common anomalies.
Apparently, seeing all the negative evidence in one place leads readers to accept our conclusion that the CAPM just doesnt work. The model is an elegantly
simple and intuitively appealing tour de force that lays the foundations of asset
pricing theory, but its major prediction that market suffices to explain the
cross-section of expected returns seems to be violated in many ways.
In terms of citations, Fama and French (1992) is high on the Journal of Finance all-time hit list. Its impact is somewhat surprising since there is little new
in the paper, aside from a clear statement of the implications of the accumulated
empirical problems of the CAPM.

C. The Three-Factor Model

An asset pricing model can only be replaced by a model that provides a better description of average returns. The three-factor model of Fama and French
(1993) addresses this challenge. The models expected return equation is,
(13)

E(Rit) RFt = bi[E(RMt) RFt] + siE(SMBt) + hi E(HMLt).

The time-series regression used to test the model is,

(14)

Rit RFt = ai + bi(RMt RFt) + siSMBt + hiHMLt + eit.

In these equations Rit is the return on security or portfolio i for period t,

RFt is the risk-free return, RMt is the return on the value-weight (VW) market
portfolio, SMBt is the return on a diversified portfolio of small stocks minus the
return on a diversified portfolio of big stocks, HMLt is the difference between
the returns on diversified portfolios of high and low B/M stocks, and eit is a zeromean residual. The three-factor model (13) says that the sensitivities bi, si, and
hi to the portfolio returns in (14) capture all variation in expected returns, so
the true value of the intercept ai in (14) is zero for all securities and portfolios i.

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Two Pillars of Asset Pricing381

The three-factor model is an empirical asset pricing model. Standard asset pricing models work forward from assumptions about investor tastes and
portfolio opportunities to predictions about how risk should be measured and
the relation between risk and expected return. Empirical asset pricing models
work backward. They take as given the patterns in average returns, and propose
models to capture them. The three-factor model is designed to capture the relation between average return and size (market capitalization) and the relation between average return and price ratios like the book-to-market ratio, which were
the two well-known patterns in average returns at the time of our 1993 paper.
To place the three-factor model in the rational asset pricing literature, Fama
and French (1993) propose (13) as the expected return equation for a version of
Mertons (1973a) ICAPM in which up to two unspecified state variables lead to
special risk premiums that are not captured by the market factor. In this view,
size and B/M are not themselves state variables, and SMB and HML are not portfolios that mimic state variables. Instead, in the spirit of Fama (1996), the factors
are just diversified portfolios that provide different combinations of covariances
with the unknown state variables. And the zero intercepts hypothesis for (14)
implies that the market portfolio, the risk-free asset, SMB and HML span (can
be used to generate) the relevant multifactor efficient set. In this scenario, (13)
is an empirical asset pricing model that allows us to capture the expected return
effects of state variables without naming them.
There is another more agnostic interpretation of the zero-intercepts hypothesis for (14). With risk-free borrowing and lending, there is one tangency portfolio of risky assets that is the risky component of all the mean-variance-efficient
portfolios of Markowitz (1952). If the tangency portfolio can be expressed as a
portfolio of the risk-free asset, the market portfolio, SMB and HML, the analysis
in Huberman and Kandel (1987) implies that the intercept in (14) is zero for all
assets. This view of the three-factor model covers the ICAPM interpretation of
Fama and French (1993) and the behavioral stories discussed later.
Kenneth French and I have many papers that address the empirical robustness of the three-factor model and the size and B/M patterns in average returns
the model is designed to explain. For example, to examine whether the size and
B/M patterns in average returns observed for the post-1962 period in Fama and
French (1992) are the chance result of data dredging, Davis, Fama, and French
(2000) extend the tests back to 1927, and Fama and French (1998, 2012) examine international data. The results are similar to those in Fama and French
(1992, 1993). Fama and French (1996, 2008) examine whether the three-factor
model can explain the anomalies that cause problems for the CAPM. The threefactor model does well on the anomalies associated with size, sales growth, and

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The Nobel Prizes

various price ratios, but it is just a model and it fails to absorb other anomalies. Most prominent is the momentum in short-term returns documented by
Jegadeesh and Titman (1993), which is a problem for all asset pricing models
that do not add exposure to momentum as an explanatory factor, and which in
my view is the biggest challenge to market efficiency.
After 1993, empirical research that uses an asset pricing model routinely
includes the three-factor model among the alternatives. When the issue is the
performance of a proposed new asset pricing model, victory is declared if the
model comes somewhat close to explaining as much of the cross-section of average returns as the three-factor model. Research on the performance of managed
portfolios (for example, mutual funds) routinely uses the intercepts (alphas)
produced by (14), often augmented with a momentum factor (for example, Carhart 1997, and more recently Kosowski et al. 2006 or Fama and French 2010).
A long time passed before the implications of the work on market efficiency
for portfolio choice had an impact on investment practice. Even today, active
managers (who propose to invest in undervalued securities) attract far more
funds than passive managers (who buy market portfolios or whole segments of
the market). This is puzzling, given the high fees of active managers and four
decades of evidence (from Jensen 1968 to Fama and French 2010) that active
management is a bad deal for investors.
In contrast, the work on the empirical problems in the CAPM model for
expected returns, culminating in Fama and French (1992, 1993), had an immediate impact on investment practice. It quickly became common to characterize professionally managed portfolios in terms of size and value (high B/M) or
growth (low B/M) tilts. And it quickly became common to use the regression
slopes from the three-factor model to characterize the tilts and to use the intercept to measure abnormal average returns (alpha).
There is longstanding controversy about the source of the size and especially the value premium in average returns. As noted above, Fama and French
(1993, 1996) propose the three-factor model as a multifactor version of Mertons
(1973a) ICAPM. The high volatility of the SMB and HML returns is consistent
with this view. The open question is: what are the underlying state variables that
lead to variation in expected returns missed by the CAPM market ? There is
a literature that proposes answers to this question, but the evidence so far is
unconvincing.
The chief competitor to our ICAPM risk story for the value premium is the
overreaction hypothesis of DeBondt and Thaler (1987) and Lakonishok, Shleifer, and Vishny (1994). They postulate that market prices overreact to the recent
good times of growth stocks and the bad times of value stocks. Subsequent price

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Two Pillars of Asset Pricing383

corrections produce the value premium (high average returns of value stocks
relative to growth stocks). The weakness of this view is the presumption that
investors never learn about their behavioral biases, which is necessary to explain the persistence of the value premium. Moreover, Fama and French (1995)
find that the high average returns of value stocks and the low average returns
of growth stocks persist for at least five years after stocks are allocated to value
and growth portfolios, which seems rather long to be attributed to correction of
irrational prices.
Asset pricing models typically assume that portfolio decisions depend only
on properties of the return distributions of assets and portfolios. Another possibility, suggested by Fama and French (2007) and related to the stories in Daniel
and Titman (1997) and Barberis and Shleifer (2003), is that tastes for other characteristics of assets play a role. (Socially responsible investing is an example.)
Perhaps many investors get utility from holding growth (low B/M) stocks, which
tend to be profitable fast-growing firms, and they are averse to value stocks,
which tend to be relatively unprofitable with few growth opportunities. If such
tastes persist, they can have persistent effects on asset prices and expected returns, as long as they dont lead to arbitrage opportunities. This is a behavioral
story, but it is not about irrational behavior. In economics, we take tastes as
given and make no judgments about them.
To what extent is the value premium in expected stock returns due to
ICAPM state variable risks, investor overreaction, or tastes for assets as consumption goods? We dont know. An agnostic view of the three-factor model
that doesnt require a choice among stories is that the model uses empirical
regularities observed in many markets to find portfolios that together span the
mean-variance-efficient set of Markowitz (1952). The analysis in Huberman and
Kandel (1987) then implies that the model can be used to describe expected
returns on all assets.
Conclusions
In my view, finance is the most successful branch of economics in terms of rich
theory, extensive empirical tests, and penetration of the theory and evidence
into other areas of economics and real-world applications. Markowitz (1952,
1959) portfolio model is widely used by professional portfolio managers. The
portfolio model is the foundation of the CAPM of Sharpe (1964) and Lintner
(1965), and it gets a multifactor extension in Merton (1973a). The CAPM is one
of the most extensively tested models in economics, it is well-known to students
in areas of economics other than finance, and it is widely used by practitioners.

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The options pricing model of Black and Scholes (1973) and Merton (1973b) is
a must for students in all areas of economics, and it is the foundation for a huge
derivatives industry. However one judges market efficiency, it has motivated a
massive body of empirical work that has enhanced our understanding of markets, and like it or not, professional money managers have to address its challenges. Its sibling, rational expectations, first exposited by Muth (1961), has had
a similar run in macroeconomics. The three-factor model of Fama and French
(1993) is arguably the most successful asset pricing model in empirical tests to
date, it cant be avoided in tests of competing asset pricing models, and it is a
handy tool that has shaped the thinking of practitioners. Can any other branch
of economics claim similar academic and applied impact?

Acknowledgments
I am grateful for the comments of George Constantinides, Douglas Diamond,
Anil Kashyap, Richard Leftwich, Juhani Linnainmaa, Tobias Moskowitz, Lubos
Pastor, Pietro Veronesi, G. William Schwert, Amir Sufi, and Richard Thaler. Special thanks to John Cochrane and my longtime coauthor, Kenneth R. French. I
am a consultant to, board member of, and shareholder in Dimensional Fund
Advisors.

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