Are the owners of great track records incredibly skilled, or incredibly lucky? This is one of the oldest questions in finance. To explore this further, I’m going to borrow from Scott Patterson and Jack Schwager, the authors of two fantastic books, The Quants and Market Wizards.

Here is Gene Fama, Nobel Laureate, the father of modern finance and longtime professor at the University of Chicago, talking to a classroom of students (The Quants, pages 77-79).

“Everything I’m about to say isn’t true,” said Fama in a gruff voice tinged with the accent of his Boston youth.

He walked to the chalkboard and wrote the following: Efficient-market hypothesis.

“The market is efficient,” Fama said. “What do I mean by that? It means that at any given moment, stock prices incorporate all know information about them. If lots of people are drinking Coca-Cola, its stock is going to go up as soon as that information is available.”

Students scribbled on their notepads, taking it all in.

The efficient-market hypothesis, perhaps the most famous and long-lasting concept about how the market behaved in the past half century, was Fama’s baby. it had grown so influential, and had become so widely accepted, that it was less a hypothesis than a commandment from God in heaven passed down through his economic prophet of the Windy City.

“There are a number of consequences to market efficiency,” Fama said, facing the classroom. “One of the most important is that it’s statistically impossible to know where the market is going to go next. This is known as the random walk theory, which means that the future course of the market is like a coin toss. It either goes up or down, fifty-fifty, know on knows which.

A student near the front row raised a tentative hand.

“What about all the guys who get paid to pick stocks? They must get paid for a reason. It can’t be all luck.”

“The evidence shows that trying to pick stocks is a complete waste of time,” Fama said flatly. “And money. Wall Street is full of salesman trying to convince people to give them a buck. But there’s never been a study in history showing active managers consistently beat the market. It’s just not in the data. Managers have good runs, but it usually just comes down to dumb luck.”

“Why do people pay these managers so much money?”

“Hope? Stupidity? It’s hard to say.”

What about Warren Buffett?”

Fama sighed. That Buffett again. Increasingly, students were obsessed with the track record of this hick investor from Omaha, whose company Berkshire Hathaway, had beaten the S&P 500 for two decades in a row and counting.

“There do seem to be a few outliers that are impossible to explain. In every science there are freaks that seem to defy all the rules. Buffet, as well as Peter Lynch at Fidelity’s Magellan fund, have had consistent returns over the years. I’m not aware of anyone else. These freak geniuses may be out there, but I don’t know who they are. Who knows,” he said with a shrug and a smile, “maybe they’ll lose it all next year.”

The math showed it was inevitable that a few traders would stand out, but that didn’t mean they had skill. Give ten thousand people a quarter. Tell them to flip. Each round, eliminate the ones who flipped heads. Each round, eliminate the ones who flipped heads. After ten rounds, maybe a hundred will be left. After twenty, maybe three or four will still be in the game. If they were on Wall Street, they’d be hailed as expert coin flippers drenched in alpha. Buffett, according to Fama, was in all probability a lucky coin flipper.

Another student raised a hand. “But you said everything you’re going to tell us isn’t true. So does that mean markets really aren’t efficient?”

That’s right,” Fama said. “None of what I’m telling you is one hundred percent true. These are mathematical models. We look at statistics, historical data, trends, and extrapolate from them. This isn’t physics. In physics, you can build the space shuttle, launch it into orbit, and watch it land at Cape Canaveral a week later. The market is far more unstable and unpredictable. What we know about it are approximations about reality based on models. The efficient-market hypothesis is just that, a hypothesis based on decades of research and a large amount of data. There’s always the chance we’re wrong.”

He paused. “Although I’m virtually certain that we’re right. God knows the market is efficient.”