Discussion of “Competing Theories of Financial Anomalies”

Abstract

In his classic 1970 paper, Eugene Fama wrote: [Efficient markets and asset pricing] research … did not begin with the development of a theory of price formation which was then subjected to empirical tests. Rather, the impetus … came from the accumulation of evidence … that the behavior … of speculative prices could be well approximated by a random walk … Faced with the evidence, economists felt compelled to offer some rationalization …. In short, there existed a large body of empirical results in search of a rigorous theory. Today, three decades later, the search for a rigorous theory continues. As before, stylized empirical facts constrain the various modeling efforts. What is different, Alon Brav and J. B. Heaton (2001) and the organizers of this conference acknowledge, is that behavioral finance determines much of the empirical and theoretical agenda. Behavioral finance is new. It studies how financial decisions in households, organizations, and markets are truly made. Decision processes are often crucial to decision outcomes. This is the main reason why behavioral finance borrows ideas from psychology. 1 In contrast, modern finance is based on the classical notion of homo economicus , that is, the normative axioms that underlie expected utility theory, risk aversion, rational expectations, and Bayesian updating. Economics does not weigh the cost of thinking. It does not treat cognition as a scarce resource. Herbert Simon (1983) calls this approach “the Olympic model.” Regrettably, fewpeople are olympians. In experiments, decision makers systematically and often willingly violate the axioms of rationality [ Tversky and Kahneman (1986), Conlisk (1996), Rabin (1998)]. Studies of real-world financial decision making strengthen this conclusion. For instance, in prior work (1998) I have sketched “a portrait of the individual investor.” The portrait is unimpressive. I list four classes of anomalies relating to irregular perceptions of the dynamics of equity prices, perceptions of value, risk management, and trading practices. What is surprising is the failure of many people to infer basic investment principles from years of experience, for example, the benefits of diversification.