The Validity of Behavioral Finance

There was quite a bit of commentary among the various behavioral finance blogs that I read this weekend. Eugene Fama did an interview with The Market NZZ (Gisiger, 2020) in which he attempted to discredit behavioral finance.

Professor Fama is quite an established individual. His 1964 doctoral dissertation, The Behavior of Stock Market Prices laid the foundation for the efficient markets hypothesis that has transformed the way finance is viewed and conducted. In 2013, he was honored with the Nobel Prize in Economic Sciences for his empirical analysis of asset prices.

The efficient market hypothesis states the belief that all information relevant to stock prices is freely and widely available, “universally shared” among all investors (Efficient Markets Hypothesis, 2019). It builds the case that all investors act in a logical manner that places them somewhere along the efficient frontier.

The existence of several market anomalies would not be possible if the efficient market hypothesis were indeed the economic law of the land. Furthermore, the works of Kahneman, Tversky, Shiller, Thaler, Ariely, and so many others have proven that behavioral biases make it incapable of humans to be completely rational in all of our decisions.

Here is the quote from Professor Fama that caused such a stir. “In my view, there is no such thing as behavioral finance. Essentially, it’s just a criticism of efficient markets. They don’t have a theory of their own. Hence, that makes me the most important person in behavioral finance. Without me, they don’t have anybody to disagree with. So, I think behavioral finance is just a branch of efficient markets” (Gisiger, 2020).

Them’s fightin’ words!

I could go on and on about the validity of his statement, but respectfully I will just sum it up as saying there has been more than enough empirical evidence to support emotionally driven decision-making when it comes to investing. So, I’ll just agree to disagree.

Rather, I’d like to point out some of Professor Fama’s behavioral biases that keep him clinging to an antiquated belief system.

Affinity Bias in this case refers to Implications whereby an individual decides to promote weak or otherwise unsound theories that reflect expressive characteristics rather than utilitarian characteristics in a misguided attempt to achieve sound rationale. He clearly has an affinity for his model and views behavioral economics, not as a growing field based on sound science, but as a personal attack against his work.

I can also pick up on Cognitive Dissonance and Conservatism bias. “When newly acquired information conflicts with preexisting understandings, individuals often experience mental discomfort— a psychological phenomenon known as cognitive dissonance” (Pompian, 2012). “Conservatism bias is a mental process in which people cling to their prior views or forecasts at the expense of acknowledging new information” (Pompian, 2012).

Joe

Efficient Markets Hypothesis - Understanding and Testing EMH. (2019, July 24). Retrieved October 13, 2020, from https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/efficient-markets-hypothesis/

Gisiger, C. (2020, October 8). Gene Fama: "Inflation is Out of the Control of Central Banks". Retrieved October 13, 2020, from https://themarket.ch/english/inflation-is-totally-out-of-the-control-of-central-banks-ld.2476

Pompian, M., (2012). Behavioral finance and wealth management : how to build optimal portfolios that account for investor biases (2nd ed.). John Wiley & Sons.