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Nov. 2014 – A Most Useful Model

The field of finance is among the most successful branches of economics thanks largely to rapid advances in computer technology that began in the early 1960s. In particular the Fama-French three factor model, which has been tested exhaustively over many time periods and throughout global markets, has emerged as the pre-eminent standard for evaluating alternative approaches to equity investment. It has been central to our success in developing sound allocation plans on behalf of our clients, despite their widely differing investment objectives and preferences.

Here we have reprinted an excerpt from an article by Eugene Fama, co-recipient of the 2014 Nobel Prize in economics, published earlier this year in American Economic Review, in which he comments on the evolution of asset pricing research.

“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’s (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. 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 can’t 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?”
Eugene F. Fama “Two Pillars of Asset Pricing.”
American Economic Review 104, no. 6 (2014): 1467-85.

Also in This Issue:

The Fed, Inflation, and Your Investment Income
Year-End Tax Considerations
From the Archives: E.C. Harwood 1977
AIER’s Inflation Assessment and Your Portfolio
Timely Tax Tips
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles