Market Efficiency versus Behavioral Finance

Abstract

Two prominent economists—one the author of A Random Walk Down Wall Street and the other a leading scholar in behavioral finance—debate the current validity of the efficient markets hypothesis (EMH). For over 30 years, the idea that capital markets are efficient and that stock prices reflect all publicly available information dominated academic thinking. But the bubble of the late 1990s and recent advances in behavioral finance have forced a re-thinking. Behavioralists argue that markets are at least “weakly” predictable. They also point to evidence that small investors —typically day traders—consistently lose money as a result of “loss aversion,”“overconfidence,” and other behaviors that are not part of the focus of EMH (though, as Malkiel notes, there is room for irrational investors in an EMH world provided there are enough rational investors to counteract and correct them). Proponents of EMH, of course, argue that neither individual investors nor active fund managers reliably outperform markets, so there is no point paying for active management. Yet these seemingly disparate views lead to important areas of common ground. In particular, both camps agree that individual investors should stick to broad-based, low-cost index funds. And retirement accounts—either 401Ks or social security accounts—should have limited investment selections in order to minimize the possibility that behavioral problems lead to investor mismanagement.