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Classic Paper: Emergence of Behavioral Finance

| | Posted in: Animal Spirits

We have selected for retrospective review a few all-time “best selling” research papers of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize the October 2002 paper entitled “From Efficient Markets Theory to Behavioral Finance” (download count over 4,100) by Robert Shiller, author of the book Irrational Exuberance. This paper traces the recent history of financial market research, from an erosion of faith in the efficient markets theory to a growing collaboration between the social sciences and finance. Shiller’s key points are:

  • In the 1970s, efficient markets theory achieved peak influence within academia as one aspect of the rational expectations revolution in economic theory. The first edition of Burton Malkiel’s book A Random Walk Down Wall Street appeared early in this decade.
  • The 1980s saw much discussion of the consistency, or inconsistency, of efficient markets theory with the empirical behavior of prices, dividends and earnings. Of special concern was an actual stock market volatility much higher than that which the theory could explain. In other words, noise is so substantial that it dominates the movements of the aggregate stock market.
  • In the 1990s, academic investigations shifted towards developing models of human psychology as it relates to financial markets. Research on feedback models (attention-driven momentum) and obstacles to smart money (impeding market rationalization) illustrate the progress of behavioral finance.
  • However, “do not expect such research to provide a method to make a lot of money off of financial market inefficiency very fast and reliably.”

In summary, human psychology and sociology can trump the forces of stock market rationalization, at least for a while.

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