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Rekenthaler Report

The Savior That Wasn't

Why behavioral economics hasn't helped active management.

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False Hope
Behavioral economics should have been a boon for active investment management. The argument for stock market efficiency and, therefore, for the superiority of index funds came from traditional economics, which treated each investor as a fully rational party. When behavioral economics showed that rationality assumption to be a fiction, with investors subject to a variety of decision-making biases, the claim for active management should have been vindicated. In a marketplace of blind participants, one-eyed professionals figured to be king.

The early research supported that notion. To the astonishment of efficient-market theorists--Eugene Fama was so surprised that he had a graduate student double-check the numbers because he doubted their accuracy--Werner De Bondt and Richard Thaler discovered in 1985 that a very simple plan of buying the stocks with the worst 36-month returns and then holding them for the next 36 months had generated outsized gains over the previous six decades. Such results could not be explained by the efficient-market hypothesis. But they could come from irrational investor overreaction, as predicted by the behavioral economists.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.