Robert Shiller, a professor of economics at Yale University, made a prediction in 2005 that a massive bubble was developing in the housing market, and was proved right just two years later, it seemed a mortal blow for classical finance. Shiller is one of the founders of behavioral finance, a school of economics that believes that the psychological behavior of investors can have a big impact on markets. As he had done with his earlier prescient forecast of irrational exuberance in the stock market bubble of the late 90s, Shiller seemed to be staging a direct attack on the Efficient Market Hypothesis (EMH), which University of Chicago economist Eugene Fama had developed three decades earlier. According to Fama, investors are always rational, and markets accurately reflect all publicly known information. In this utopian world, securities will always be appropriately priced, and no amount of analysis can result in outperformance. Shiller, for his part, vehemently disagrees.
The Efficient Market Hypothesis is one of the most egregious errors in the history of economic thought, he says. Its a half-truth.
As Shiller suggests, the financial crisis of 20082009 seems to have given a major boost to behavioral finance theory, and its advocates are not shy in declaring victory. If the argument is that people are perfectly rational, then we have won the argument, says Dan Ariely, a professor of behavioral economics at Duke Universitys Fuqua School of Business.
Yet, when the bubble burst, very few investors actually made any money from the subsequent market crash. Even funds that employ behavioral techniques to influence their investing fell sharply in 2008 along with the rest of the market. Its true that some hedge funds made huge profits betting against subprime-mortgage-backed securities, but Richard Thaler, a professor at the Booth School of Business at the University of Chicago and a founding theorist of behavioral finance, says its almost impossible to earn a living making such investments.
The world isnt structured in a way that somebody could create a fund that will bet against bubbles when they appear, because youd be on the sidelines a lot of the time and youd go through really hard times, says Thaler, who works as a principal at Fuller & Thaler Asset Management in San Mateo, California, when he isnt teaching finance or doing academic research.
Like Thaler, the fund managers employing behavioral finance are not betting against bubbles. Instead, they believe that investors make mistakes because of cognitive and emotional biases such as a presumption that a stock that has performed well in the past will continue to do so far into the future that cause equity prices to either overreact or underreact to market news. It is these mispricings that behavioral finance strategies attempt to exploit.
Over the past 15 years, there has been a steady increase in the number of fund managers that are using behavioral finance concepts to select stocks and construct portfolios. One estimate is that half of the 200 listed small-cap value funds use some form of behavioral finance in selecting their portfolios. Such firms as Fuller & Thaler, Chicago-based LSV Asset Management and even fund behemoth J.P. Morgan Asset Management have deployed strategies that use behavioral concepts to select equities for their portfolios. And all of them are beating their market benchmarks over the long term.
In addition, a growing number of investment companies, ranging from Des Moines, Iowabased Principal Global Investors to Catalpa Capital Advisors, a New York hedge fund firm headed by Joseph McAlinden, a former chief investment officer for Morgan Stanley, are using behavioral finance tools to help shape their portfolios, even if they are not the mainstay of their investment strategy.
Yet critics are dubious of behavioral claims. Ray Ball, a professor of accounting at the University of Chicago, complained recently that behavioral finance is not a theory, but merely a collection of ideas and results that depend for their existence on the EMH. Other critics cite the fact that behavioral finance has not produced much data to support its arguments. Fama tells Institutional Investor he still believes behavioral investing is really just another name for choosing value stocks that have a higher cost of capital, which gives them higher expected returns.
Active managers as a whole cant beat the market, he says. Thats impossible.