From Efficient Markets Theory to Behavioral Finance (Digest Summary)

Proponents of behavioral finance view finance from a broad social science perspective
that includes psychology and sociology. Unlike efficient market theorists, they believe
that asset prices are not always driven by rational expectations of future returns. The
author maintains that behavioral finance has become a vital research topic because it
addresses many market anomalies that efficient market theory ignores.

The most significant market anomaly that efficient market theory fails to explain is
excess volatility. The idea that stock prices change more than they rationally should is
more troubling for efficient market theorists than any other anomaly, such as the
January effect or the day-of-the-week effect. If most of the volatility in the stock
market is unexplained, then efficient market theory can be easily challenged. Efficient
market theory says that asset prices can be forecast using the present discounted value
of future returns. Yet because of excess volatility, forecasts of stock prices based on
this idea tend to be more unreliable than the prices themselves. Some efficient market
theorists argue that prices are efficient at the individual stock level but not at the
aggregate market level, but others concede that the level of volatility in the overall
stock market cannot be explained with any variant of the efficient market model.

In contrast to efficient market theory, one of the oldest ideas in behavioral finance,
going back three centuries to Holland's tulip mania, is that of price-to-price feedback.
In other words, prices go up because prices went up. Speculators talk of “new
era” theories to justify price increases, but a bubble can be sustained only by
expectations of further price increases; at the first instance that the expectation is
proven false, the bubble bursts. This feedback theory, largely ignored by those in
finance, is supported by psychological and “natural” experiments, as in the
case of pyramid schemes.

One of the criticisms of feedback theory is that price changes are strongly serially
correlated, but that is not the case. Feedback models incorporate exponentially
declining weights on past prices through time, as well as other shocks to the system, to
explain price changes. The price effect operates at a low frequency that can be observed
only over a long period of time. The shocks affect day-to-day price changes.

Efficient market theory suggests that prices are kept in line with rational expectations
by the interaction between “smart money” and “ordinary
investors.” Accordingly, the smart money sells when the irrationally optimistic
ordinary investor buys, and buys when the irrationally pessimistic ordinary investor
sells. This theory, however, requires smart money to engage in short selling, which is
often not possible, at least not in the volume required to offset the irrational
optimists. Thus, irrational price changes occur. Again, the author argues, the efficient
market theory is unable to reconcile this fact.

In light of such discrepancies, the author concludes that to better understand the
markets, behavioral finance must be incorporated into new economic models. Efficient
market models, although useful as ideals, cannot provide accurate descriptions of real
markets. In addition, the author warns that we should “distance ourselves from the
presumption that financial markets always work well and that price changes always
reflect genuine information.”