TCS Daily

Are We All Behaviorists Now?

By Stephen Bainbridge - October 20, 2004 12:00 AM

The Wall Street Journal (sub. req'd) recently published a fascinating article on the debate between efficient capital markets theorists (exemplified by Eugene Fama) and behavioral economists (exemplified by Richard Thaler). As the Journal explained:

For forty years, economist Eugene Fama argued that financial markets were highly efficient in reflecting the underlying value of stocks. His long-time intellectual nemesis, Richard Thaler, a member of the "behaviorist" school of economic thought, contended that markets can veer off course when individuals make stupid decisions.

In May, 116 eminent economists and business executives gathered at the University of Chicago Graduate School of Business for a conference in Mr. Fama's honor. There, Mr. Fama surprised some in the audience. A paper he presented, co-authored with a colleague, made the case that poorly informed investors could theoretically lead the market astray. Stock prices, the paper said, could become "somewhat irrational."

Coming from the 65-year-old Mr. Fama, the intellectual father of the theory known as the "efficient-market hypothesis," it struck some as an unexpected concession. For years, efficient market theories were dominant, but here was a suggestion that the behaviorists' ideas had become mainstream.

"I guess we're all behaviorists now," Mr. Thaler, 59, recalls saying after he heard Mr. Fama's presentation."

The debate between Thaler and Fama matters a lot -- a whole lot.

The efficient capital markets hypothesis (ECMH) is one of the most basic -- and influential -- principles of modern corporate finance theory. During the 1980s, for example, the Securities and Exchange Commission (SEC) relied on the ECMH to justify many deregulatory initiatives. In the capital markets, acceptance of the ECMH by investors drove the burgeoning popularity of indexing as an investment strategy. The ECMH's validity thus has enormous implications both for the way in which we invest and how the government will regulate the capital markets. As the Wall Street Journal put it, the debate affects a host of "real-life problems, ranging from the privatization of Social Security to the regulation of financial markets to the way corporate boards are run."

The ECMH's fundamental thesis is that, in an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. As applied to stock markets, the ECMH thus has two principal implications. First, stock prices follow a random walk. Put another way, the ECMH predicts that price changes in securities are random. Randomness does not mean that the stock market is like throwing darts at a dart board. Stock prices do go up on good news and down on bad news. Randomness simply means that stock price movements are serially independent: future changes in price are independent of past changes. In other words, investors can not profit by using past prices to predict future prices.

Second, the ECMH posits that current prices incorporate not only all historical information but also all current public information. This form predicts that investors can not expect to profit from studying publicly available information about particular firms because the market almost instantaneously incorporates information into the price of the firm's stock.

The ECMH assumes investors are rational actors whose behavior is consistent with that predicted by the rational choice model. Over the last decade or so, behavioral economists (such as Thaler) have drawn on experimental economics and cognitive psychology to identify systematic departures from rational decisionmaking, even in market settings. Put another way, behavioral economics claims that humans tend to make decisions in ways that systematically depart from the predictions of rational choice.

The ECMH has been one of the behavioralists' favorite targets. Thaler and others have argued that markets are made of human actors, who bring to bear their own individual foibles. Idiosyncratic valuations generate noise that may skew the market's valuation of stock prices. (Just as it is hard to carry on an accurate conversation in a noisy room, it is hard to accurately value stocks in a noisy market.) Research in cognitive psychology suggests that investor idiosyncrasies do not always cancel one another out. Instead, investors sometimes act like a herd all running in the same direction, which can produce pricing errors. Large speculative bubbles that appear out of nowhere and crash without apparent reason are the most visible form of this phenomenon.

The behavioralists have also identified a host of lesser anomalies that are hard to explain in ECMH terms. Stocks tend to suffer abnormally large losses in December and on Mondays. Stocks with low price/earnings ratios tend to outperform the market, as do stocks of the smallest public corporations. Big round numbers (like 10,000) tend to act as psychological barriers. And so on.

So is Thaler right? Are we all behavioralists now? Well, perhaps not quite.

There is considerable evidence that markets adapt to investor irrationality over time. If investor irrationality produces pricing errors, it becomes possible to profit by taking advantage of them. At one time, for example, the capital markets showed a systematic bias against small cap firms. As a result, it was possible to earn abnormal returns by investing in a portfolio weighted towards small caps. Over time, many investors did so, including a substantial number of mutual funds that specialized in small cap investing. As a result, the small cap anomaly gradually faded to the point at which it was no longer possible to systematically beat the market by investing in them. We have observed much the same with respect to other anomalies. Hence, there is considerable evidence that experienced traders can learn their way out of the irrational behavior patterns that lie at the bottom of so many market anomalies.

Accordingly, while the ECMH may not be perfect, it still probably does a better job of predicting market behavior over time than any of the behavioral theories. Indeed, Richard Thaler apparently admitted as much to the WSJ:

Mr. Thaler ... concedes that most of his retirement assets are held in index funds, the very industry that Mr. Fama's research helped to launch. And despite his research on market inefficiencies, he also concedes that "it is not easy to beat the market, and most people don't."

So where are we? It is clear that behavioral economics can identify instances in which the capital markets are inefficient, some of which persist for very long periods and /or across many market sectors. Yet, on balance, the capital markets still appear to be pretty efficient, if not perfectly so.

What then should investors and regulators do? As for investors, they should still treat Burton Malkiel's Random Walk Down Wall Street as the investment bible. In the last section of Random Walk, Malkiel distills ECMH and the related concept of portfolio theory into an eminently practical life-cycle guide to investing based on two propositions. First, diversification. Second, no one systematically earns positive abnormal returns from trading in securities; in other words, over time nobody outperforms the market. Mutual funds may outperform the market in 1 year, but they may falter in another. Once adjustment is made for risks, every reputable empirical study finds that mutual funds generally don't outperform the market over time. Malkiel's recommendation therefore is that you should put your money into no-load passively managed index mutual funds, which by the way appears to be precisely where behavioralist Thaler puts part of his money even though he also operates a investment advisor that uses behavioral principles.

As for regulators, because the ECMH is often brought to bear as a justification for deregulation in politically charged policy disputes, such as mandatory corporate disclosure and insider trading, those who support regulation of such areas find comfort in the behavioral critique. One problem with such arguments, of course, is that it takes a theory to beat a theory, and no behavioralist theory yet advanced does a better job of explaining the vast bulk of stock market phenomena than the ECMH.

Assume, however, that markets frequently behave irrationally due to behavioral biases. The mere existence of such a market failure does not -- standing alone -- justify legal intervention. In addition to the standard prudential arguments in favor of limited government, which counsel caution in concluding that a purported market failure requires government correction, behavioral economics itself argues against presuming the desirability of intervention. As NYU law professor Jennifer Arlen observed in a Vanderbilt Law Review article:

"Proposals designed to address biases generally entail the intervention of judges, legislators, or bureaucrats who are [themselves] subject to various biases. The very power of the behavioralist critique -- that even educated people exhibit certain biases -- thus undercuts efforts to redress such biases. In addition, the decisions of government actors also may be adversely influenced by political concerns -- specifically interest group politics. Thus interventions to "cure" bias-induced inefficiency may ultimately produce outcomes that are worse than the problem itself. "

In other words, the claim that law can correct market failures caused by decisionmaking biases or cognitive errors treats regulators as exogenous to the system. Once the state is indigenized, however, regulators must be treated as actors with their own systematic decisionmaking biases. It thus becomes evident that behavioral economics loops back on itself as a justification for legal intervention.

My bottom line? Put your money in passively managed index funds and vote for free markets.

Stephen M. Bainbridge is a professor at the UCLA School of Law, where he teaches corporate and securities law. He is the author of Corporation Law and Economics and publisher of the widely-read blog He is a TCS contributor.


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