Global Trend

The "Efficient Market Hypothesis" Gives Way to "Behavioral Finance"

The ¡°efficient market hypothesis,¡± which Wall Street embraced for decades, holds that in a market where everyone has equal access to the same information, rational investors will set stock prices ? and the prices will reflect the generally understood information about the value of those stocks. No one has an unfair advantage ? and no one is supposed to be able to beat the market over the long term. This is the foundation upon which the $1 trillion index-fund industry rests.

Economist Eugene Fama is recognized as the most passionate proponent of this thesis. On the other side of the economic aisle is Richard Thaler, a ¡°behavioral¡± economist who argues that markets can behave erratically when investors make irrational, or even dumb, decisions ? and understanding this irrationality can provide a competitive edge.

The Wall Street Journal reported on a gathering of 116 economists at the University of Chicago Graduate School of Business last May for a conference that was to honor Professor Fama. He presented a paper that shocked many in the audience. In it, Fama argued that investors who either didn¡¯t understand the market or who were uneducated about its basic principles could, in fact, cause the market to veer off in unexpected ways. The paper concluded that stocks could reach ¡°somewhat irrational¡± levels, and hence gave powerful ammunition to Fama¡¯s intellectual opponents.

There is a lot at stake behind what might appear to be an academic rivalry. Fama¡¯s works, and his faith in an efficient market, were the lynchpins that created the index-fund industry. And the reverberations may be felt in the upcoming debates on partially privatizing Social Security, the future regulation of markets, and even the way company boards must govern.

This new recognition of the role of emotions in markets was officially acknowledged in 2002, when the Nobel Prize in Economics was awarded to Dr. Daniel Kahneman. Kahneman isn¡¯t an economist. He¡¯s a psychologist. His choice as the winner of the top prize in economics demonstrates just how much behavioral finance ? and the study of how irrationality informs the market ? has gained credibility and influence.

It¡¯s always been recognized that the stock market was driven by fear and greed. But now, we¡¯ve begun to recognize and evaluate additional psychological factors. The market is increasingly seen as not being ¡°efficient¡±; rather, it¡¯s nervous and acts out neurotically. And, the implications of its unease have a widespread effect on our economy and on your personal portfolio.

Looking at the market through the lens of behavioral psychology, let¡¯s decipher what¡¯s changed since the start of the millennium, and what that will mean for you as you strive to manage and protect your wealth.

The old view was simplistic. It held that individual investors made rational decisions based on their own interests and their processing of information about the direction of the economy. When they were feeling confident and informed, they invested confidently. When they saw trouble, they ran to safety.

Terrorism is just one of life¡¯s new wrinkles that has changed the game and provided additional insights for behavioral economists. We all know that 9/11 detonated a disastrous economic explosion on Wall Street. Similarly, individual investors ran for cover when 190 people were killed in a terrorist attack on a commuter train in Madrid last March. That sent the Dow down 169 points ? the largest decline of the year, and another example of behavioral finance at work.

Basically, behavioral finance recognizes that human behavior is only sporadically informed by reason. Probably the first time this idea hit the national consciousness was when the usually taciturn Federal Reserve Chairman Alan Greenspan offered, in a 1996 speech, that investors might be suffering from ¡°irrational exuberance¡± in ratcheting the stock market to such lofty levels.

His insight proved to be correct, and three and a half years later the bubble burst. It was that stock market collapse that provoked so much new interest in behavioral finance. Robert Shiller, a Yale professor, wrote the best-selling Irrational Exuberance in 2000, which tried to analyze and give strong credence to the psychological factors in investing.

Informed investors have suspected that emotion has always had a strong influence on our views about money and investing, but we¡¯ve tended to emphasize perfectly rational theories that have tried to tame that unruly notion. But now the behaviorists are making progress in building practical theories that help guide investment decisions and government policies.

What does this mean for you as an investor? If the efficient market hypothesis was correct, an investor would beat the S&P 500 index over the long term only if he was lucky. But, under behavioral economics, it may be possible to have specific insights on how psychology affects investor decisions. Those who can harness this insight to anticipate those effects will achieve superior results over the long term.

Among specific investment strategies gleaned from behavioral economics, consider these eight from the Contrarian Investing Association:

Buy stocks of companies that have disciplined plans for achieving dramatic long-term growth in both profits and revenues. Such companies must also have inherent qualities that make it difficult for new entrants into that business to share in such growth.

Focus on such companies when they are out of favor; i.e., market conditions are not favorable, or the financial community does not properly perceive the true worth of such companies.

Hold the stocks that you buy until there has been either a fundamental change in the company¡¯s nature, or it has grown to a point where it will no longer be growing at a faster rate than the economy as a whole. Investors should never sell their most attractive stocks for short-term reasons.

If your primary investment goal is long-term appreciation of capital, then you should de-emphasize the importance of dividends.

Recognize that making mistakes is an inherent cost of investing. The important thing is to recognize such mistakes as soon as possible, understand their causes, and learn from them so they are not repeated. A willingness to take small losses in some stocks while letting profits grow bigger and bigger in your more promising stocks is a sign of good investment management. Don¡¯t just take profits for the satisfaction of taking them.

Realize that there is a relatively small number of truly outstanding companies. Your funds should be concentrated in the most desirable opportunities. For individuals (in possible contrast to institutions and certain types of mutual funds), any holding of over 20 different stocks is a sign of financial incompetence. Ten or 12 is usually a better number.

An important ingredient of successful investing is to have more knowledge and apply your judgment after thoroughly evaluating specific situations. You should also have the moral courage to act against the crowd when your judgment tells you that you are right.

One of the basic rules of life also applies to successful investing ? success is highly dependent upon a combination of hard work, intelligence, and honesty.

Investment companies are recognizing behavioral finance and incorporating it into the way they offer their services. For example, according to The Atlanta Journal Constitution, the Northwestern Mutual insurance firm acknowledges a whole list of psychological barriers to successful investing.

The firm¡¯s research identified several ¡°blind spots¡± including ¡°loss aversion¡± ? that is, it hurts more to lose money than it feels good to receive the same amount ? and ¡°framing,¡± that is, how an investment is presented can affect the financial decisions.

When looking at your own investing decisions, or for those who sell investments to others, it¡¯s good to keep in mindseven mental biases identified by The Journal of Behavioral Finance that often hinder investors in making successful decisions:

Mental accounting ? the tendency to value some dollars less than others.

Myopic loss aversion ? the tendency to avoid short-term losses at the expense of long-term gains.

Sunk cost fallacy ? the tendency to ¡°throw good money after bad.¡±

Status quo bias ? the tendency to want to keep things the way they are.

Endowment effect ? the tendency to consider something you own to be worth more than it would be if you didn¡¯t own it.

Regret aversion ? the tendency to avoid taking an action out of fear it will be a mistake.

Money illusion ? the confusion between ¡°real¡± and actual changes in money, such as the impact of inflation on purchasing power

Those who are interested in learning more about behavioral economics should watch for the forthcoming book Mean Markets and Lizard Brains: How to Profit from the New Science of Irrationality by Terry Burnham, which will be summarized in the January 2005 issue of Audio-Tech Business Book Summaries.

Beyond the theoretical and personal finance implications, the Trends editors foresee the rise of behavioral economics and the decline of the efficient market hypothesis having a significant impact on public policy and corporate governance. Therefore, we offer the following five forecasts for your consideration:

First, expect to see the efficient market hypothesis wilt under the mounting anecdotal evidence that it simply no longer describes market reality. We are learning in economics, as in other areas of scientific inquiry, that much of what we¡¯ve previously deemed to be ¡°randomness¡± is actually deterministic activity masked by complexity. Behavioral economics is helping us strip away that complexity and understand the mechanisms that lie underneath.

Second, the likely partial privatization of Social Security portends the introduction of more individual investors with even less sophistication. This means that emotion is likely to play an even larger role in market movements. So, the Trends editors expect those who design the coming overhaul to use behavioral psychology to identify potential pitfalls. Richard Thaler, the behavioral economist we cited earlier, studied Sweden¡¯s retirement system, where investors are free to choose from a vast number of investment options. He found that the Swedish investors generally made bad decisions, such as over-weighting their portfolios in risky technology stocks and domestic stocks. He concluded Sweden offered too many options, which makes sensible decisions difficult. Thaler believes that Social Security reform in the U.S. should include fewer options. He explains, ¡°If you give people 456 mutual funds to choose from, they¡¯re not going to make great choices.¡±

Third, as the efficient market hypothesis is abandoned, companies will increasingly begin to reassess tying executive compensation to share price. With the share price being largely determined by factors beyond the control of the CEO and other executives, a company risks over- or under- compensating them. In either case, the interests of the shareholders and other stakeholders may not be well served.

Fourth, the terror premium that hangs over the market is likely to continue to suppress values until the public sees that militant Islam has been contained. The Trends editors believe that the S&P 500 is undervalued by roughly 20 percent relative to fair market value, largely because of geopolitical uncertainty. Once it becomes clear that Al Qaeda and related organizations are unable to launch large-scale attacks, this market discount will disappear.

Fifth, index funds are likely to lose their luster as investors learn that the primary rationale for owning them no longer has credibility. The $1 trillion index-fund industry rests upon the foundation of the efficient market hypothesis. While a certain market segment is likely to cling to this investment vehicle, the Trends editors expect its overall share of the investment pie to drop sharply. The winners are likely to be the actively managed funds with the best long-term track records.

References List :
1. The Wall Street Journal, October 18, 2004, "Stock Characters," by Jon E. Hilsenrath. ¨Ï Copyright 2004 by Dow Jones & Company, Inc. All rights reserved.2. Irrational Exuberance by Robert J. Shiller is published by Princeton University Press. ¨Ï Copyright 2000 by Robert J. Shiller. All rights reserved.3. The Atlantic Journal ? Constitution, August 24, 2004, "Mind Over Money ¡®Behavioral Finance,¡¯ Which Deals with Emotions, Comes into Play as Stocks Languish Despite Strong Economic News," by Tom Walker. ¨Ï Copyright 2004 by The Atlanta Journal ? Constitution. All rights reserved.4. Mean Markets and Lizard Brains: How to Profit from the New Science of Irrationality by Terry Burnham is published by John Wiley & Sons, Inc. ¨Ï Copyright 2005 by Terry Burnham. All rights reserved.5. South Florida Sun ? Sentinal, August 27, 2004, "Math or Psychology: Figuring Out Investing," by Chet Currier. ¨Ï Copyright 2004 by South Florida Sun ? Sentinal. All rights reserved.