Fair Game

Since the 1960s, University of Chicago Graduate School of Business finance professor Eugene F. Fama has championed the efficient market hypothesis, a concept which has dominated financial theory for more than 30 years. The hypothesis, which states that stock prices fully reflect the most complete and best information available, has been a stubborn obstacle for active investors determined to find ways to beat the market. If the market is efficient, the rule for investors is simple: You can't beat consistently a simple index of stock prices.

But over the last few years, a new school of investing called behavioral finance has become popular with professional and amateur investors alike and has challenged the foundations of the efficient market hypothesis. Led by Fama's colleague and fellow Chicago researcher Richard Thaler, behavioral finance theorists claim that you can, in fact, beat the market. By carefully studying investor behavior, active money managers can identify profitable clues about what stocks to buy and when. Backed by compelling evidence from cognitive psychology, the new school believes that investors often make predictable, systematic mistakes when processing information about the stock market. Because of shared human foibles such as overconfidence, greed, or fear, people make errors in judgment, and these mistakes, in turn, can be observed, recorded and exploited by other investors who are wise to the game.

But Fama is not convinced. In his recent paper "Market Efficiency, Long-term Returns, and Behavioral Finance," he defends the theory of efficient markets by dismantling the opposing arguments one by one.

"There is a developing literature that challenges the efficient market hypothesis, and argues that stock prices adjust slowly to information, so one must examine returns over long horizons to get a full view of market inefficiency," says Fama. "If one accepts their stated conclusions, many of the recent studies on long-term returns suggest market inefficiency, specifically, long-term investor underreaction or overreaction to information. It is time, however, to ask whether this literature, viewed as a whole, suggests that efficiency should be discarded. My answer is a solid no."

Behavioral Finance and Long-term Return Literature

One of the first papers to spark the behavioral finance field was written in 1985 by Werner DeBondt of the University of Wisconsin and Richard Thaler now of the University of Chicago Graduate School of Business. Analyzing long-term return anomalies dating back to 1933, they found that when stocks were ranked on three- to five-year past returns, past winners tended to be future losers and visa versa. The theory asserts that stocks performing poorly will actually do very well on average over the next few years. According to this theory, it is good strategy to buy these undervalued stocks.

Thaler and DeBondt attribute these long-term return reversals to investor overreaction, which is the notion that investors overreact to information about companies and stocks, sending prices to unnaturally high or low levels. However in the subsequent years, investors will realize they were overreacting to the news and stock prices will drift to their correct levels. In the lag time, investors who are aware of the overreaction can make money on the correcting price drift.

Other behavioral finance literature suggests that investors may also make the mistake of underreacting to financial news. For example, after a company announces good news, such as higher than expected returns, investors may initially underreact to the news, not pushing the stock price high enough and only gradually incorporating its full import into the stock price. People can make money in the short-term lag as the prices correct themselves upwards or downwards.

"The granddaddy of underreaction events is the evidence that stock prices seem to respond to earnings for about a year after they are announced," says Fama.

Supporters of behavioral finance say that evidence of investor overreaction and underreaction signals an inefficient market, yet Fama believes they have not made a case strong enough to replace the efficient market theory.

Fragile Evidence

"If apparent overreaction was the general result in studies of long-term returns, market efficiency would be dead, replaced by the behavioral alternative of DeBondt and Thaler," says Fama. "In fact, the apparent underreaction is about as frequent."

In other words, investor biases such as investor overreaction and underreaction are short-lived and random occurrences that can be effectively explained within the traditional theory of market efficiency. He rejects recent long-term return studies for two main reasons.

First, says Fama, an efficient market generates "categories of events" that individually suggest that prices overreact to information. But in an efficient market, apparent underreaction will be about as frequent as overreaction. If anomalies split randomly between underreaction and overreaction, they are consistent with market efficiency.

Second, and more important, "If the long-term return anomalies are so large they cannot be attributed to chance, then an even split between over- and underreaction is a Pyrrhic victory for market efficiency." He found, however, that the long-term return anomalies are sensitive to methodology. They tend to become marginal or disappear when exposed to different models for expected returns or when different statistical approaches are used to measure them. Thus, even viewed one-by-one, says Fama, "most long-term anomalies can be reasonably attributed to chance."

Risk Factors

If behavioral finance theorists are correct, then it appears investors can beat the market by taking advantages of investor mistakes. This troubles efficient market supporters like Fama because it suggests that stock price discrepancies that can be profitably exploited, based on ideas from human psychology, without increased risk. Efficient market theorists would explain that investing in value stocks produces higher returns simply because there is more risk in the investment for which investors must be compensated.

Fama acknowledges that the efficient market hypothesis -- like all models -- is not a bullet-proof description of price formation, but that following the standard scientific rule, market efficiency can only be replaced by a better specific model of price formation, itself potentially rejectable by empirical tests. Fama argues that the behavioral finance camp has not come up with a good alternative to market efficiency.

"The alternative hypothesis to market efficiency is vague, market inefficiency," says Fama. "This is unacceptable."

Viewed as a whole, he says, the long-term return literature in the field does not identify overreaction or underreaction as the dominant phenomenon. The random split predicted by market efficiency "holds up rather well," says Fama.

He adds that the problem with much of the behavioral science literature is that it doesn't encompass the whole picture. Many behavioral models work well on the anomalies they are designed to explain, such as investor overreaction or underreaction, but when applied to other anomalies, "the results are embarrassing," he says.

"The bottom line is that the evidence against market efficiency from the long-term return studies is fragile," says Fama. "Reasonable changes in the approach used to measure abnormal returns typically suggest that apparent anomalies are methodological illusions." With reasonable changes in the way they are measured, long-term return anomalies -- the crux of the opposition -- often disappear.

Given the fact that cognitive psychologists can generate "a long litany of investor judgment biases," Fama says it is safe to predict that "we will soon see a menu of behavioral models that can be mixed and matched to explain specific anomalies. My view is that any new model should be judged on how it explains the big picture. The question should be: Does the new model capture the menu of anomalies better than market efficiency? For existing behavioral models, my answer to this question, perhaps predictably, is an emphatic no."