What behavioral finance teaches about investments, and investors.
Once an outsider, behavioral finance has become thoroughly mainstream. Findings from behavioral finance have altered how traditional, “rationalist” researchers, who subscribe to the efficient market hypothesis, view both the financial markets and those who participate in those markets. For this issue’s Morningstar Conversation, we discuss what behavioral finance has taught us about the markets and its investors—and what the rationalists always had right, from the beginning. Participating in our discussion are Christine Benz, Morningstar’s director of personal finance; Lee Davidson, the firm’s head of quantitative research; Paul Kaplan, research director for Morningstar Canada; and Steve Wendel, head of behavioral sciences with Morningstar. The roundtable took place in August.
John Rekenthaler: Let’s start with the markets and how investors price securities. Over the past few decades, many researchers have documented the existence of so-called anomalies, the alleged outperformance of value stocks, securities with price momentum, etc. To start, do these anomalies exist or are they accidental findings?
Lee Davidson: I think of an anomaly as anything that is a deviation away from the capital asset pricing model, or CAPM, theory that was postulated in the 1960s.
When we observe a pricing pattern, a return pattern that doesn’t match up with what our expectations would be under CAPM, we say there is an anomaly. There is virtually no disagreement between the rationalist and behavioralist camps that such anomalies exist. Actually, there’s much agreement about what those anomalies are. I think most of the disagreement comes down to how do we best measure them and how do we interpret why they’re there.
Rekenthaler: Is it fair to say that, back in the day, the rationalists, the followers of CAPM, might have viewed these anomalies as being in conflict with their belief system and they somewhat adjusted their belief system to accompany them?
Davidson: That’s true. You see rationalists first grappling with the anomalies—maybe they are just temporal dislocations; they aren’t going to be permanent—and then when they do end up being permanent, this camp tried to come up with explanations rooted in reason. These are rational, risk-based explanations for why these anomalies should exist and continue to exist.
Rekenthaler: Behavioral finance folks—the behavioralists— have never had a problem explaining the existence of these anomalies: Investors often act irrationally. Not too long ago there was a strong disagreement between these two camps about the existence of these anomalies. Today, we really have reached a consensus, right?