Two Theories About Investing. Two Nobel Prizes. Who is Correct?

Shari Greco Reiches and I have been speaking quite a bit about a fascinating area of investing called Behavioral Finance, and I am often asked where the underlying ideas came from. So let’s take a step back … into the 1960s.

The ’60s were a very exciting time for lots of reasons! Paul Kantner, guitarist for Jefferson Airplane used to say, “If you can remember anything about the sixties, you weren't really there.”

But those who were around may remember the rapid evolution of economic theories about stock prices and stock markets, due in part to advances within computing. Faster processing speed made it possible to dissect and analyze stock prices. 

An economic theory developed that investors acted like these computers, efficiently and accurately taking into account all available information and making rational decisions about prices.

And in 1970, Eugene Fama, a professor at the University of Chicago, published a groundbreaking paper which crystallized this thinking into what is called the Efficient Markets Hypothesis. Professor Fama was awarded a Nobel Prize in Economics for his work.

But Economics is a field in which two people can get a Nobel Prize for saying exactly the opposite thing. And that’s what happened here.

An Israeli economist named Daniel Kahneman said, basically, “not so fast, Professor Fama.” Professor Kahneman didn’t think that in the real world, people always made investment decisions rationally. His research led to a new field of economics called Behavioral Finance, for which he was awarded a Nobel Prize. 

His field, Behavioral Finance, is the flip side of the coin of Efficient Markets Theory.

Behavioral Finance says that investors often make irrational decisions because of the baggage they bring to the table with them. This baggage is called biases, and there are two kinds: 

• Cognitive biases are systematic errors in thinking that do not reflect reality. 
• Emotional biases cause investors to make decisions based on feelings.

A cognitive bias comes about because our brains are wired to think quickly, an ability that has helped humans survive over time. To think quickly, we sometimes take mental shortcuts, which are called heuristics. These heuristics can be useful, but sometimes they lead to mistakes.

Emotional biases, too, can lead to investing mistakes. Often we are inclined to believe something that has a positive emotional effect, or we are reluctant to accept hard facts that are unpleasant.

So which theory is correct, Efficient Markets or Behavioral Finance? The economists continue to debate this. But there is a consensus that elements of both theories are helpful in understanding how markets work and how investors think. 

While markets may not always be priced efficiently, it’s very difficult to beat them in the long-term, so it pays to act as if they are efficient (Efficient Markets theory). 

How to do so? We’ve written quite a bit on this topic—accept the market’s returns by investing in index funds or similar funds that closely track the market’s returns. Stay disciplined, think long-term and don’t try to time when to get in and out.

So next we’ll turn to Behavioral Finance, to understand why investors make common mistakes, and how to encourage them to avoid doing so.

In our few blogs, we’ll take a look at specific examples of these mistakes, the biases behind them, and well offer some coaching tips to help counter them. 

The goal—helping you to make the best investment decisions for your situation.

 

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The author does not intend to provide investment, legal or tax advice as these materials are for general educational purposes only.  Please consult your legal, tax or investment professional for advice on your particular situation. This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. It is not intended to be a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction. Investing involves risk including the possible loss of principal. Past performance does not guarantee future results. Please refer to RRCM’s Form ADV Part 2 for additional disclosures regarding RRCM and its practices.