The Intersection of Efficient Markets and Behavioral Finance

I know I contradict myself when I say it, but I believe in both Efficient Markets and in the effects of Behavioral Finance.

They both equally fascinate and convince me.

At a very simplistic level, here’s a primer on each of them:

Efficient Markets

The Efficient Market Theory points to the data sources, and they are extensive, of how improbable it is to consistently outperform the market.

An investor (or Mutual Fund Manager, for that matter) may be able to outperform for a short amount of time, but it’s neither sustained nor sustatinable.

Basically, their performance reverts to the mean, or worse (underperformance).

Those that ascribe to the Efficient Market Theory advise that, since it’s improbable to beat the market, an investor is best served with a buy and hold strategy of passively managed Index Funds or passively managed Exchange Traded Funds.

Behavioral Finance

This theory ascribes to the fact that people behave irrationally, especially when it comes to money.  They buy high and they sell low.  They herd in and out of the market.  They have a massive avoidance to realize any sort of loss.  They do all kinds of very funny goofy things that have no basis whatsoever in the actual logical reasons to buy or sell an investment.

See how those 2 can contradict each other?  If markets are efficient, then investors’ behavior shouldn’t influence them one way or another.

Yet in the short term at least they do.

But over time and even with the painful corrections the markets do go up, and if you are applying the principles of Dollar Cost Averaging (both in and out), and you are diversified, and your asset allocation is aligned to your timeframe, you should do just fine.

But usually our behavior does get in the way: We freak out and do things that jeopardize our plans and goals for our future.

So that’s why it fascinates me and why I believe in both: Yes, markets overall are efficient, but at certain times are hugely affected by investors’ financial behaviors.

Today’s market news reinforces that (and I hope this isn’t my Recency Bias talking!)

(I am a Fee-Only Financial Planner.)