Efficient Markets vs Behavioral Finance



A few notes from some of my research for you to ponder over the weekend…


Efficient Markets Theory

The efficient markets theory is the idea that speculative asset prices always incorporate the best information about fundamental values and that prices change only because new information enters the market and investors act in an appropriate, rational manner with regards to this information(i). This idea dominated academic fields in the early 1970s. Efficient markets theory is an elegant attempt to tether asset prices to fundamentals through the common-sense notion that people would not behave in irrational ways with their money in financial markets. This theory is encapsulated by the “value investment” paradigm prevalent in much of the investment community.

Efficient Markets Theory

In an efficient market, prices are tethered to perceived fundamental valuations. If prices fall below the market’s perception of fundamental value, then buyers will enter the market and purchase the asset until prices reach their perceived value. If prices rise above the market’s perception of fundamental value, then sellers will enter the market to sell the asset at inflated prices. Efficient markets theory explains the majority of market behavior, but it has one major flaw which renders it inoperable as a forecasting tool: it does not explain those instances when prices become very volatile and detach from their fundamental valuations. This becomes painfully obvious when adherents to the theory postulate new metrics to justify fundamental valuations that later prove to be completely erroneous. The failed attempts to explain anomalies with the efficient markets theory lead to a new paradigm: behavioral finance theory.

Behavioral Finance Theory

Behavioral Finance abandoned the quest of the efficient markets theory to find a rational, mathematical model to explain fluctuations in asset prices. Instead, behavioral finance looked to psychology to explain asset valuation and why prices rise and fall. The primary representation of market behavior postulated by behavioral finance is the price-to-price feedback model: prices go up because prices have been going up, and prices go down because prices have been going down. If investors are making money because asset prices increase, other investors take note of the profits being made, and they want to capture those profits as well. They buy the asset, and prices continue to rise. The higher prices rise and the longer it goes on, the more attention is brought to the positive price changes and the more investors want to get involved. These investors are not buying because they think the asset is fairly valued, they are buying because the value is going up. They assume other rational investors must be bidding prices higher, and in their minds they “borrow” the collective expertise of the market. In reality, they are just following the herd. This herd-following has long been a valid investment technique employed by traders known as “momentum” investing(ii). It is not investing by any conventional definition because it relies completely on capturing speculative price changes. Success or failure often hinges on knowing when to sell. It is not a “buy and hold” strategy.

Behavioral Finance Theory

Behavioral Finance Theory

The efficient markets theory does explain the behavior of asset prices in a typical market, but when price change begins to feedback on itself, behavioral finance is the only theory that explains this phenomenon. There is often a precipitating factor causing the break with the normal pattern and releasing the tether from fundamental valuations. In the Great Housing Bubble, the primary precipitating factor was the lowing of interest rates. The precipitating factor simply acts as a catalyst to get prices moving. Once a directional bias is in place, then price-to-price feedback can take over. The perception of fundamental valuation is based solely on the expectation of future price increases, and the asset is always perceived to be undervalued. There are often brave and foolhardy attempts to justify these valuations and provide a rationalization for irrational behavior. Many witnessing the event assume the “smart money” must know something, and there is a widespread belief prices could not rise so much without a good reason: Herd mentality takes over.

Psychological Stages of Bubble Market

Psychological Stages of a Bubble

(i) Much of the history of the Efficient Markets theory is outlined in Robert Shillers paper (Shiller, From Efficient Market Theory to Behavioral Finance, 2002), “The efficient markets theory reached the height of its dominance in academic circles around the 1970s. Faith in this theory was eroded by a succession of discoveries of anomalies, many in the 1980s, and of evidence of excess volatility of returns. Finance literature in this decade and after suggests a more nuanced view of the value of the efficient markets theory, and, starting in the 1990s, a blossoming of research on behavioral finance. Some important developments in the 1990s and recently include feedback theories, models of the interaction of smart money with ordinary investors, and evidence on obstacles to smart money.”

(ii) In House Prices, Fundamentals and Bubbles (Black, Fraser, & Hoesli, 2006), the behavior of momentum investors is characterized as evidence against rationality in the marketplace. For the typical amateur speculator this is certainly true, but for momentum traders who have learned how to buy and sell to profit from the momentum, it is a rational and profitable method of speculation.

29 thoughts on “Efficient Markets vs Behavioral Finance

  1. joe

    Any explanation of the stock and housing asset bubbles that doesn’t incorporate the Fed’s role and Mr. Greenspan’s indifference to bubbles isn’t complete.

    Also, I question if those who loaned, chopped and repackaged these mortgages are going to lose. It seems we’re bailing out our non-banking financial system to avoid an economic collapse.

    We have privatized institutionalized profits but socialized their losses.

  2. zoiks

    Robert Shiller likes to talk about information cascades. I believe it’s when you use the knowledge of what choices other people are making to inform your own choices. Like deciding to go to a restaurant that’s full of people rather than the empty one, based on seeing the people inside.

    It’s not totally irrational to use other people’s judgment to inform your decisions. Kids do it – they learn how to act largely by mimicking adults. And in the restaurant example, it’s reasonable to expect that the restaurant packed with people is more likely to be a better restaurant than the empty one next door. Not always true, but more likely anyway.

    But sometimes these “information cascades” take on a life of their own and the activity of others becomes the sole source of information, regardless of merits. It’s obvious to see this can then lead to bad decision making.

    JMHO (Hopefully I’m not screwing up the theory too badly, but this is how I see it.)

  3. granite

    Mr. Realty Times thinks its “a good bet” that the market will recover later this year. Its no wonder he didn’t use Dr. Shiller as one of his experts.

    I do think there were two primary factors. In order to get this “double bubble” the no down easy money financing added the extra boost beyond low interest rates. Enabling millions of people who would normally never have qualified to participate gave the rocket boost somewhere around 2003 (and Bush’s “Ownership Society”). I believe you made this point yourself earlier.

    The trick seems to be identifying and following momentum. Then getting out before everyone else does.

  4. alan

    My understanding of market theory, as a non-economist, is that it was designed to explain markets where goods were bought and sold using money belonging to the buyers and sellers.

    No matter how you slice it, this market was sustained by OPM, other-peoples-money. Prices hikes were perpetuated by speculators buying multiple properties using OPM with little skin in the game.

    To my knowledge, the models you describe do not account for the effect of speculators and OPM.

  5. IrvineRenter

    Your analysis is right on. It is exactly how the research literature describes it. Herd mentality in investing is taking a useful survival skill and applying it in the wrong context resulting an asset bubble.

  6. IrvineRenter

    The description of the two theories of finance was not intended as a complete description of asset bubble, nor of the housing bubble in particular.

    I totally agree with you that the actions of the FED and the secondary mortgage market enabled the bubble to get inflated. I have gone into detail on the issues you describe in other posts.

  7. george8

    Alan, a great point. I wonder if IR or anyone with more finance and math research backgroung could further charaterize the role of financial leverage in the great housing bubble, or in any bubble market for that matter.

  8. BD

    Hello All –

    …quick question for the board – where do people reasonably believe prices will be on a per square foot basis in Mission Viejo or Coto / Ladera Ranch when we bottom?

    Thanks, for any and all ideas…


  9. Varangy


    While I think your summation of EMT is pretty good — I think that you are being a bit reductionist and have perhaps too much faith in behavioral finance ability to offer insight. A lot of what EMT suggests is more, much more applicable to the financial markets, not to the real estate markets.

    IMHO, painting with a broad brush, financial markets in general are semi-strong form efficient, while I think that real estate is anything but. That is why financial market corrections are drastic and quick — and real estate market corrections are drawn-out bloody affairs.

  10. BD

    I would disagree… the only difference between housing markets and other financial market is liquidity.



  11. Varangy


    There are vast differences between the real estate markets and the financial markets. Liquidity and continuity being some of them.

    This is a decent article on how efficiency is defined. Might be interesting for those of you w/o a finance/economics background.


  12. Emma Anne

    And it isn’t even that no one realizes a bubble is happening. I didn’t participate in this housing bubble, but I remember lots of nervous jokes around 1999-2000 that when you are getting stock tips from the modern day equivalent of the shoe shine boy it was time to sell. But even if you know you are in a bubble, how do you know when it will pop, and what do you do in the meantime?

    On the one hand, people are saying “buy and hold” and “dollar cost averaging.” On the other hand you have bears, but they have been saying things would crash for the last 3 years and if you had listened to them, you would never have seen your 401K (house, whatever) go up. If you leave your money in cash, inflation eats it up and how do you ever retire?

    So even the bubble formation isn’t without some rational thought. People just don’t know what else to do.

  13. IrvineRenter

    These two theories are broad conceptual frameworks for understanding how and why prices rise and fall. As concepts they can apply to all markets irrespective of the application of leverage in the buying and selling of assets within the market.

    The housing bubble was first and foremost a credit bubble inflated with borrowed money. Many financial bubbles come about due to some form of unsustainable credit expansion and Ponzi type financing. The housing bubble we have just witnessed will be a textbook example of a financial bubble built on credit.

  14. IrvineRenter

    Most current research in economics is in behavioral finance as most of the ideas of the efficient markets theory have been widely discredited due to their failure to account for the observed volatility in financial markets.

    This housing bubble is going to be the first true bubble in the housing market. In the first coastal bubble of the late 70s, prices did not fall much after the peak, and the market did not experience the fear or capitulation stages true bubble markets experience. The coastal bubble of the late 80s did see significant market price corrections, but most homeowners held on and did not capitulate to the market. The slow correction of prices in both of those bubbles did not correct quickly because the market never saw true capitulatory selling as people gave up and sold just to get out of their investments. This bubble is shaping up to be different. Prices have already fallen so far, so fast that many people will give up either due to an inability to make payments or by the fact they are so far underwater there is no hope of them getting back to breakeven in a reasonable amount of time. When people lose hope, they will sell in large numbers consistent with capitulatory behavior witnessed in true financial bubbles. Capitulatory selling is witnessed in stock markets all the time, but this will likely be the first time in a housing market. All of the talk of price “stickiness” will be rewritten by the time this bubble is done deflating.

  15. BD

    I appreiciate all of the analysis but, it seems to me that most of this can be expained by simple reasoning. That is people were allowed to spend far more than they could afford because of nearly free money and “innovative” financing. These people did so because the could simple enough. Unless you are a cash buyer you have what you have because the bank says you can have it. During the boom / bubble you could have anything. Based on these unprecedented easy money terms anyone could have bought anything. You could have bought the Staple Center with no documentation with someone else’s money. Kidding but, you get the idea.

    Now after the ponzi scheme of greater fools has run its course we are left with the largest asset bubble the world has ever seen – simple as that.

    The process of correction or reversal to fundamental affordability is going to be brutal. Prices are still 25-40% overvalued based on traditional metrics and affordability. This process of correction is going to destroy more wealth than anything we have ever seen and keep prices below trend growth for a decade or more. We basically stuffed 20 years of appreciation into 5 or so years here in CA.

    With most of the homes IR is profiling reflecting hundreds of thousands of loss ask yourself – if banks increase downpayment requirements to 20% how long does it take you to save that same amount as a down payment… $100K, or $200K?

    Just MHO..


  16. BD

    People buy payments not prices.

    There are idiots out there now buying cars with an 8 year note! Houses with a 40 year note!

    Stupid and crazy… but, this is what our educational system has brought us….


  17. GreenspanIsATraitor

    “People buy payments not prices.

    There are idiots out there now buying cars with an 8 year note! Houses with a 40 year note!

    Stupid and crazy… but, this is what our educational system has brought us….

    You got that RIGHT ! The dumbing down of America has been a GREAT SUCCESS.

  18. Dr. Dan

    A couple of comments:

    (1) “People buy payment not prices” to which I would add people sell for the price and in most cases it will be the holder of the mortgage that really paid at that price.

    (2) The tech bubble crash and 9/11 caused many people to desire hard asset investments such as real estate (a safe haven of sorts).

    (3) The analysis is incomplete in that (and really aren’t articles on this yet) low interest rates helped to continue the housing bubble but the “event” that started this whole thing was really a “demand surge” which really did dry up the housing supply, which caused prices to go up, which caused people to want to invest in housing. The “demand surge” was new innovative financing (aside from the low interest rates) that allowed people 1 or 2 years down the buying pipeline to in fact be able to “buy now” so we had several years of demand suddenly come due all at once. It was this demand surge the kicked off the housing bubble (it started the fire)….low interest rates just put the fuel on the fire. So my view is that the conventional wisdom that low interest caused the housing bubble is wrong…that was an exacerbating factor, albeit a significant one.

  19. GreenspanIsATraitor

    “(2) The tech bubble crash and 9/11 caused many people to desire hard asset investments such as real estate (a safe haven of sorts).

    You know, its funny at that time, I was selling everything I had to buy all the gold and silver I could get my hands on. Gold at $296
    an ounce, and silver at $4.88 an ounce….geeessshhhh seems like they were literally GIVING it away! Thanks to my Dad for teaching me all about what REAL MONEY was.

    Along with buying a shit load of puts on New Century, and CountryWide has allow me the independence Ive always DREAMED OF. Thank you Alan Greenspan, your stupidity has made me a FORTUNE!

    Ah, loving LIFE !

  20. GreenspanIsATraitor


    By chance you watching Hawaii real estate?
    I want to buy a nice place in Ohau…
    Any idea when you think prices there will “bottom out” ?
    Thanks in advance.

  21. TurtleRidgeRenter

    My guess is $160 – 180, since those places are so far away from the beach. Maybe other folks here know a little more about the area, and can shed some better light.

  22. Lisa

    IMHO, all these models and theories can’t apply to current market condition. With the financial tools such as no-doc, zero down, neg-am etc., this is a “you have nothing to lose” gamble game, and there is no rational financial theory can justify the phenomena we have experienced in the housing market.

  23. Chris_Silicon_Valley

    Make that a 4. Retiring at 37? Oh goody, hope he/she has enough moola for that monthly health insurance payments.

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