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What are the critics saying?

Critics of behavioral finance concede that biases do exist. However, there is a limit to the importance and actual impact of the biases, since people actively search out opportunities to exploit such behavior. In summarizing this viewpoint, Lo (2005) stated: “While all of us are subject to behavioral biases from time to time, (traditional economic theorists) disciples argue that market forces will always act to bring prices back to rational levels, implying that the impact of irrational behavior on financial markets is generally negligible, and, therefore, irrelevant.”

One of the most cited critics of behavioral finance is Fama (1997). This paper demonstrates that the behavioral finance is not a rigorous theory, and when subject to particular methodologies, falls apart at the seams. He shows that the anomalies pointed out by advocates of behavioral finance are actually just chance results, and support for the anomalies tends to disappear with changes in the way they are measured.

Fama, Eugene F. (1997). Market efficiency, long-term returns, and behavioral finance. Journal of Financial Economics, 49, 283-306.

Goedhart, Koller and Wesels contend that although the behavioral approach to financial markets lends some useful insights, significant discrepancies between market value of investments, and intrinsic value of investments are rare. Markets and individual share prices that “are out of sync with economic fundamentals usually come back into proper alignment relatively quickly.” They use a number of illustrative examples, such as the mispricing experience of 3Com Corp and its subsidiary, Palm Inc. along with the mispriced shares of the Royal Dutch/Shell Group and the Shell Transport & Trading Co. Through these examples, they show that mispricing is an uncommon and temporary phenomenon that occurs only under very special circumstances, and when those circumstances shift, “rational investors will step in to drive share prices back to intrinsic value.”

Goedhart, Marc H., Koller, Timothy M. & Wessels, David. (2005). What really drives the market? MIT Sloan Review, 47(1), 21-24.

Curtis pointed out a number of methodological limitations to behavioral finance studies that use experimental designs. First, participants in experiments generally know that they are in an experiment and hence change their behavior accordingly, either because they are in an unnatural environment or are trying to please (displease) the researcher. Second, participants do not always follow instructions. Third, the phrase ‘statistically significant’ doesn’t necessarily mean that an effect is significant in magnitude. Third, in cases where the effect did not occur for all participants (i.e. the effect occurred in 60% of the cases), experimenters rarely question why some participants did not succumb to the effect (i.e. what happened to the other 40%?) Fourth, experience and education often matter – once investors realize their biases, they are likely to change. Fifth, the results of an experiment may differ if there is something important at stake for the participants. Finally, the experimenter’s expectations of the outcome may impact how the participants behave.

Curtis, Gregory. (2004). Modern Portfolio Theory and Behavioral Finance. 16-22.

Although not a critic of behavioral finance, Lo reviews the case for and against the traditional economic hypotheses and behavioral finance hypotheses. From this, he describes a new framework called the Adaptive Market Hypothesis. Within this new paradigm, modern financial economic theory and behavioral finance can coexist in an “intellectually consistent manner.” The Adaptive Market Hypothesis is based on the principles of biology. It is premised on the idea that the laws of natural selection determine the evolution of the markets, which are constantly in flux. Behavioral biases are simply heuristics that are taken out of context (i.e. ways of thinking that have not kept up with changes in the environment) and not necessarily examples of irrationality. Lo gives the following example: “The flopping of a fish on dry land may seem strange and unproductive, but under water, the same motions propel the fish away from its predators.” The following propositions describe the essence of the theory:

• Individuals act in their own self-interest.
• Individuals make mistakes.
• Individuals learn and adapt.
• Competition drives adaptation and innovation.
• Natural selection shapes market ecology.
• Evolution determines market dynamics.

Lo, Andrew W. (2005). Reconciling efficient markets with behavioral finance: The adaptive markets hypothesis. The Journal of Investment Consulting, 7(2), 21-44.

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