As long as enough other investors notice this myopic overpricing and respond by taking short positions, the share price will fall in line with its underlying indicators. Some investors might expect a company that surprises the market in one quarter to go on exceeding expectations. When investors assume that a company’s recent strong performance alone is an indication of future performance, they may start bidding for shares and drive up the price.

Limits to arbitrage in financial markets. Hence behavioral-finance theory argues that patterns of overconfidence, overreaction, and overrepresentation are common to many investors and that such groups can be large enough to prevent a company’s share price from reflecting underlying economic fundamentals-at least for some stocks, some of the time. Only when their irrational behavior is also systematic (that is, when large groups of investors share particular patterns of behavior) should persistent price deviations occur. Even if individual investors decided to buy or sell without consulting economic fundamentals, the impact on share prices would still be limited. Others are excessively conservative and underprice stocks of companies that have released positive news. Some investors, for example, attach too much importance to recent events and results, an error that leads them to overprice companies with strong recent performance. Investors behave irrationally when they don’t correctly process all the available information while forming their expectations of a company’s future performance. When all three apply, the theory predicts that pricing biases in financial markets can be both significant and persistent. When markets deviateīehavioral-finance theory holds that markets might fail to reflect economic fundamentals under three conditions. Therefore, managers should continue to use the tried-and-true analysis of a company’s discounted cash flow to make their valuation decisions. In fact, significant deviations from intrinsic value are rare, and markets usually revert rapidly to share prices commensurate with economic fundamentals. But for managers, the critical question is how often these deviations arise and whether they are so frequent and significant that they should affect the process of financial decision making. We agree that behavioral finance offers some valuable insights-chief among them the idea that markets are not always right, since rational investors can’t always correct for mispricing by irrational ones. And current debates in the United States and elsewhere about privatizing Social Security and other retirement systems may hinge on assumptions about how investors are likely to handle their retirement options. In the 1980s the rise of stock market index funds, which now hold some $1 trillion in assets, was caused in large part by the conviction among investors that efficient-market theories were valuable. According to this point of view, significant and lasting deviations from the intrinsic value of a company’s share price occur in market valuations. (eds.), New York: Elsevier North-Holland, 2003, pp. Thaler, “A survey of behavioral finance,” in Handbook of the Economics of Finance: Financial Markets and Asset Pricing, G. 429–37 and Nicholas Barberis and Richard H. Ritter, “Behavioral finance,” Pacific-Basin Finance Journal, 2003, Volume 11, Number 4, pp. 1 1.įor an overview of behavioral finance, see Jay R.

A number of finance scholars and practitioners have argued that stock markets are not efficient-that is, that they don’t necessarily reflect economic fundamentals. Some behaviorists would even assert that stock markets lead lives of their own, detached from economic growth and business profitability. With the exuberance of the high-tech stock bubble and the crash of the late 1990s still fresh in investors’ memories, adherents of the behaviorist school are finding it easier than ever to spread the belief that markets can be something less than efficient in immediately distilling new information and that investors, driven by emotion, can indeed lead markets awry. But lately, the view that investors can fundamentally change a market’s course through irrational decisions has been moving into the mainstream. During four decades, the academic theory that financial markets accurately reflect a stock’s underlying value was all but unassailable. There’s never been a better time to be a behaviorist.

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