Behavioralists Agree: Crazy Market Is Tough to Beat

It's one of the great investment contradictions. Yes, stock investors do all kinds of goofy things. No, beating the market isn't easy. On the face of it, this seems absurd. If some folks behave irrationally, others should be able to make money at their expense. Yet, as is patently clear from the long-run market-lagging performance of most stock-mutual funds, it is awfully difficult to beat the market. This isn't just an issue of how to manage money. It is also a raging debate among finance professors. For years, the prevailing academic wisdom was that the stock market was highly efficient, with prices set by rational investors. But lately, that notion has come under assault from behavioralists, who argue that market movements aren't adequately explained by traditional economic models. No doubt about it, irrationality is on display everywhere. Why do investors trade so much? All that buying and selling can't be rationally justified. Why do companies bother splitting their stocks, say, two for one? All it means is that shareholders now have twice as many shares, each with a 50% smaller claim on the company's earnings. Why do companies pay dividends? From the standpoint of taxes, it makes far more sense to buy back stock. Yet shares often rise after a company announces a dividend increase. "It doesn't look to me like markets behave as if investors are rational," says Richard Thaler, an economics professor at the University of Chicago. Mr. Thaler, the best-known behavioralist, is now using his insights to manage money, including three funds for Undiscovered Managers, a Dallas fund company. The largest of the three, the $173 million Undiscovered Managers Behavioral Growth Fund, has returned a cumulative 120.7% since its launch two years ago, compared with 55.6% for Standard & Poor's 500-stock index. "Everybody agrees that there are some irrational investors out there," Mr. Thaler says. "The controversial question is whether they set prices. The behavioralist line is that they do some of the time. The efficient-market line is that prices are set by rational traders." Not all behavioral quirks hurt market efficiency. Many investors, for instance, are excessively self-confident. This shows up in investors' ill-advised tendency to trade too much and to bet heavily on a limited number of stocks. But it also manifests itself in the huge effort made to find undervalued stocks, says Mark Rubinstein, a finance professor at the University of California at Berkeley. Mr. Rubinstein, a proponent of efficient markets, squared off against Mr. Thaler in a debate at a November 1999 conference organized by the Berkeley Program in Finance. "I concede that investors are overconfident," Mr. Rubinstein says. "But what this means is that active managers spend too much on research. It makes the markets too efficient. It's like a gold mine where most of the gold has already been taken out. Occasionally, you'll find some, which will egg you on. But it's just not cost-effective to keep mining." Mr. Thaler says the validity of behavioral economics doesn't hinge on being able to beat the market. "It could be that stock prices were wildly irrational, but unpredictable," he says. "If so, it wouldn't be possible to make money." Indeed, even if you buy the behavioralist argument that the markets aren't entirely efficient -- and the evidence is compelling -- that doesn't mean you should try to beat the market. No matter where investors stand on the academic debate, they "should behave as if markets are efficient," argues William Sharpe, a finance professor at Stanford University and a 1990 winner of the Nobel Memorial Prize in Economic Science. Consider the 1987 stock-market crash, when the Dow Jones Industrial Average plunged 22.6% in a single day. It stands out as a glaring example of irrational behavior on a grand scale. But that doesn't mean you can predict the next bear market, says Meir Statman, a finance professor at Santa Clara University. "The market may be crazy," he says. "But that doesn't mean you can beat it." After all, if the overall market is a tad screwy, the blame lies with us, the market's participants. "Individuals make mistakes," says Hersh Shefrin, also a finance professor at Santa Clara University. "Markets aggregate those mistakes. But in the aggregation, the errors become smaller than those made by individuals. As a result, if you set out to try to beat the market, you're more likely to fail than to succeed," after figuring in investment costs. Even Mr. Thaler, who has turned his hand to money management, readily concedes that beating the market isn't easy. "The academic dispute doesn't translate into very big differences in advice for individual investors," he says. "The efficient-market guy says it's impossible for the individual investor to make money. The behavioralist will look at the data and say most individual investors don't make money. So they would both give the same advice, which is to buy and hold." The bottom line? The behavioralists may offer some slim hope to the market's stock jockeys. But in the end, it still makes a ton of sense to settle for average market results, by purchasing index funds. Write to Jonathan Clements at


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