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Market theory passed through two distinctly different paradigms in the past 80 years and is experiencing the rise of a third. Those transitions have marked the introduction of improved ways to explain price movements. The ascendant paradigm, based on new research in the field of behavioral economics, promises to offer superior guidance to investors and advisors who hope to exploit market inefficiencies.
The first paradigm was launched in 1934 with Graham and Dodd’s (GD) Securities Analysis, which provided the first systematic approach to analyzing and investing in stocks. GD argued that it was possible to build superior stock portfolios using careful fundamental analysis and a set of simple decision rules. These rules were based on the emotional mistakes made by the market that could be identified via fundamental analysis. The success of GD is all the more impressive because their book appeared in the depths of the Great Depression, when stocks were crashing and market volatility was reaching levels not seen before nor since.
GD’s dominance lasted 40 years, until the ascendency of modern portfolio theory (MPT) in the mid-1970s. MPT agreed that there were many emotional investors, but there were enough rational investors to arbitrage away pricing mistakes. Therefore market prices were “informationally efficient.” A consequence of this theory was that it was not worth conducting a GD-type of analysis, or any analysis for that matter. Instead, an investor should simply buy and hold an index portfolio.
MPT immediately ran into problems with the publication of two studies: Sanjay Basu’s study demonstrating that stocks with low price-to-earnings ratios outperformed high PE stocks and Rolf Banz’s study demonstrating that small stocks outperformed large stocks. MPT had no answer for these anomalies. In order to save the model, the two were sucked into MPT as “return factors.” It has been downhill for MPT ever since, with study after study uncovering one anomaly after another.
As MPT rose to prominence, a parallel research stream explored how individuals actually made decisions. The conclusion of this behavioral science research was that emotions and heuristics dominate decision-making. It is amazing how little rationality was uncovered in these studies!Because of the many problems facing MPT and the growing awareness of the provocative behavioral science results, we are currently witnessing the decline of MPT and the rise of behavioral finance. Among other things, this transition brings back Graham and Dodd as an important way to avoid emotional investment decisions and analyze the market’s faulty pricing mechanism.