Market Efficiency vs. Behavioral Finance

Market Efficiency

Market Efficieny says that the market occasionally gets things wrong, but it is 90% efficient.

Something may be statistically significant but not economically significant, so you cannot profit off the information.

There is a little bit of predictability as to when returns are going to be high or low, but not enough to do the investor any good because no one can predict the exact point when markets will turn.

Ex. Robert Shiller predicited very low or negative returns from the early 1990's. The 1990's were actually a propsperous time for wall street.

There are a handful of funds that outperform a broad index of stock, however, there is no way to tell in advance which ones these are going to be.

When there is an imperfection in the market, lots of people see it and act on it, which is why it is so hard to beat the market.

There are enough rational traders that there are no arbitrage opportunities. Malkiel estimates that if ten percent of investors were rational, that would be sufficient for market efficiency.

Dick Thaler, a behavioralist at the University of Chicago, believes that markets could be 90% inefficient.

According to Sendhil Mullainathan of Harvard University, "If we know that there's a bus coming down the road sometime, but we just don't know when, we'll probably take a very different attitude toward waiting for the bus than if we have no idea whether there will ever be a bus. If the market is overvalued, and if I have a long enough horizon, I might simply decide to be a lot less aggressive in equities because I don't want to get nailed in one short, big drop."

Both Market Efficiency and Behavioral Finance give the same advice to investors: buy index funds.