Classical vs Behavioral Economics - Market Efficency?

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understandingJH
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Classical vs Behavioral Economics - Market Efficency?

Post by understandingJH »

Quick question, the efficient market hypothesis, this stems from classical (rational) economic model right? If behavioral economics is a better model, does that call into question the efficient market hypothesis?

There is a lot written on behavioral economics, and I just finished Dan Ariely's class over at Coursera.org, The Beginner's Guide To Irrational Behavior. In short, all of us are much more irrational than we think we are (which is why many of us maintain AAs and try to avoid market timing because we can act on emotion, rather than cold analytical rational thought).
Wagnerjb
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Re: Classical vs Behavioral Economics - Market Efficency?

Post by Wagnerjb »

Just because many people make irrational financial decisions doesn't mean the overall market behaves irrationally. A few large well-capitalized individuals (or firms) that act rationally can keep the market efficient.

EMH is also based on data from capital markets. If we observe irrational behavior by the markets, we will be able to conclude that the markets are irrational. We just haven't found any of this evidence yet.

Best wishes.
Andy
larryswedroe
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Re: Classical vs Behavioral Economics - Market Efficency?

Post by larryswedroe »

First, the two models are not totally mutually exclusive. In other words the world is more grey than black and white.

Second, in the large sense the EMH holds. However there are many anomalies that it cannot explain--small growth stocks, IPOs, stocks in bankruptcies, and any investment with lottery like distribution has poor risk adjusted returns. on other side is value stocks seem to have too high a premium to be explained by risk--though here IMO there are good stories on both sides--so some risk and some behavioral. And now we know that stocks with relatively high gross profitability have returns that are "too high" to be explained by risk (though there is at least some risk story here). And the big challenge is MOM, which is not a risk story at all, but purely behavioral.

So the question is due to blindly adhere to EMH, ignoring strong evidence on some assets that have poor characteristics (like HY) because you just believe that markets are efficient and prices must be right, or do you go where the weight of the evidence suggests, making sure though that the data has a logical story, is persistent across markets and can be captured after costs. To me the latter is the best approach--screening out from your portfolio the assets with poor risk/adjusted returns and trying to capture the premiums in the assets/strategies with good risk/adjusted returns.

Just one man's opinion.

I hope that is helpful

Larry
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tadamsmar
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Re: Classical vs Behavioral Economics - Market Efficency?

Post by tadamsmar »

understandingJH wrote:Quick question, the efficient market hypothesis, this stems from classical (rational) economic model right? If behavioral economics is a better model, does that call into question the efficient market hypothesis?

There is a lot written on behavioral economics, and I just finished Dan Ariely's class over at Coursera.org, The Beginner's Guide To Irrational Behavior. In short, all of us are much more irrational than we think we are (which is why many of us maintain AAs and try to avoid market timing because we can act on emotion, rather than cold analytical rational thought).
Some claims of behavioral economics do not conflict with EMH. Some behavioral finance just involves an irrational pattern of risk avoidance, like DCAing a lump sum. Also, mere overall selling low and buying high does not imply the ability to pick investments relative to each other for good or ill, so it does not conflict with the EMH. I am not sure if behavioral economics makes any claims that conflict with the EMH.
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speedbump101
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Re: Classical vs Behavioral Economics - Market Efficency?

Post by speedbump101 »

Wagnerjb wrote:Just because many people make irrational financial decisions doesn't mean the overall market behaves irrationally. A few large well-capitalized individuals (or firms) that act rationally can keep the market efficient.

EMH is also based on data from capital markets. If we observe irrational behavior by the markets, we will be able to conclude that the markets are irrational. We just haven't found any of this evidence yet.

Best wishes.
I too just completed the afore mentioned Coursera (Ariely) course. Regarding EMH and irrationality, I can't help but wonder if the net result of the crowds irrationality (not necessarily herding) might in fact result in an outcome more rational than the individual parts of the equation? Slightly mind bending IMO.

SB....
"Man is not a rational animal, he is a rationalizing animal" -Robert A. Heinlein
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tadamsmar
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Re: Classical vs Behavioral Economics - Market Efficency?

Post by tadamsmar »

speedbump101 wrote: I too just completed the afore mentioned Coursera (Ariely) course. Regarding EMH and irrationality, I can't help but wonder if the net result of the crowds irrationality (not necessarily herding) might in fact result in an outcome more rational than the individual parts of the equation? Slightly mind bending IMO.
That's true in sense that markets exists in part to provide liquidity, there is no liquidity without price differences, and people who think one price is right tend to consider it irrational to be willing to buy or sell at a different price.
stlutz
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Re: Classical vs Behavioral Economics - Market Efficency?

Post by stlutz »

Conceptually at least, there is a difference between "efficient" markets and "rational" markets.

EMH originally was an explanation of why those with the most information (professionals) could not outperform the market averages--when new information becomes available, it is very quickly (i.e. "efficiently") incorporated into prices. As such, the conclusion is that detailed financial analysis, following news events and so forth will not provide additional returns.

The idea of "rational" markets implies value judgments about how the "Chicago School" of economists believe markets should work and do work. This approach argues not only that new information is quickly incorporated into prices, but that it does so "correctly." So, for example, they argue that the should be risk premiums and therefore there are. As such, the best way to find which investments were the riskiest are to look for the ones that performed the best.

Behavioralists generally don't question the Chicago School's definition of "rational" so much, but do argue that market results are not rational. For them, anomalies tend to be evidence of persistent and common errors in human judgment.

Regardless, what is interesting is that both approaches tend to believe that patters they've observed should be expected to persist. Thus, for example, both say value stocks and small stocks will outperform, just for different reasons. For investors, a more interesting/useful perspective would then be to listen to those who argue that they won't.
larryswedroe
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Re: Classical vs Behavioral Economics - Market Efficency?

Post by larryswedroe »

Here's the problem
While investor mistakes can cancel out--too optimistic investors can cancel out too pessimistic ones, and arbitrageurs can drive prices to rational levels (efficient levels)

But that only works in frictionless world. There are limits to arbitrage and fears and institutional rules against margin and high costs of shorting that can allow mispricings to persist--the way for rational investors to act in the face of the anomalies is to take advantage of them by avoiding the ones with over pricing and tilting to those with under pricing

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Clearly_Irrational
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Re: Classical vs Behavioral Economics - Market Efficency?

Post by Clearly_Irrational »

I subscribe to the "super weak form" of the EMH. The market is mostly efficient and it's growing more efficient over time but isn't 100% efficient even for public information.
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Frengo
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Re: Classical vs Behavioral Economics - Market Efficency?

Post by Frengo »

Markets are rather efficient; single investors not quite.
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