Misbehaving

Thaler collaborated, he explains, with graduate student Werner De Bondt to explore the influence of psychology in financial markets, focusing on the concept of overreaction. Despite skepticism from colleagues, they pursued the idea that psychological factors, particularly investors’ tendency for extreme forecasts based on limited information, could predict unobserved effects in stock markets. This approach was contrary to the prevailing EMH, which asserts market prices accurately reflect all available information, making consistent outperformance impossible.

Using historical stock data, Thaler and De Bondt ranked companies on the New York Stock Exchange based on their performance over several years, labeling the best and worst performers as “Winners” and “Losers,” respectively. They hypothesized that if investors overreacted, driving stock prices too high or too low based on recent performance, this would result in a regression to the mean over time. Thus, “Loser” stocks, those undervalued due to negative sentiment, were expected to outperform “Winner” stocks in subsequent years.

Their findings strongly supported this hypothesis. Stocks classified as “Losers” significantly outperformed the “Winners,” contradicting the EMH by demonstrating that past performance could indeed predict future results. This study provided compelling evidence of generalized overreaction in financial markets and highlighted the impact of psychological factors on investment decisions, challenging traditional economic theories on market efficiency.

Thaler discusses the implications of his and Werner De Bondt’s finding that “Loser” stocks (those with poor past performance) tend to outperform “Winner” stocks (those with good past performance). This finding challenges the EMH, which posits that market prices reflect all available information, making it impossible to consistently outperform the market. To reconcile these findings with the EMH, critics suggested the “Loser” stocks must be riskier, thus justifying their higher returns.

The Capital Asset Pricing Model (CAPM) was the standard measure of a stock’s risk, focusing on its correlation with the market, known as beta. However, Thaler and De Bondt’s research showed “Winner” stocks had higher betas than “Loser” stocks, contradicting the notion that higher returns of “Loser” stocks were due to greater risk.

Eugene Fama and Kenneth French, staunch supporters of the EMH, recognized the anomaly in returns related to company size and value. They developed the Fama-French Three Factor Model, adding size and value as factors influencing stock returns, but did not have a theoretical basis for why these should be risk factors. Later, they expanded this to a five-factor model, adding profitability and investment aggressiveness as factors.

Despite the evolution of these models, there is no conclusive evidence value stocks are riskier. The debate continues between those who see the higher returns of value stocks as evidence of market inefficiency and those who attribute it to unidentified risk factors. Thaler suggests that in a rational world, beta would be the only factor that matters, but the persistence of other factors like size, value, and momentum indicates markets do not always behave rationally, challenging the foundations of the EMH.

Thaler discusses the debate surrounding the EMH, particularly its claim that stock prices are always “right,” meaning they accurately reflect intrinsic value. Robert Shiller’s work challenged this claim, asserting stock prices are too volatile to be justified by changes in dividends, which should be the basis of a stock’s value. Shiller’s analysis showed that, unlike dividends, stock prices fluctuate wildly, suggesting they are not always rational predictions of future dividends.

Shiller’s findings sparked controversy and debate in financial circles, with various attempts to refute his conclusions. However, the dramatic and inexplicable stock market crash on October 19, 1987, known as Black Monday, when stocks fell globally without any significant news, seemed to support Shiller’s view that market prices can be excessively volatile and thus not always “right.”

Shiller also extended his analysis to the housing market, creating the Case-Shiller Home Price Index. Like with the stock market, he found home prices could also diverge significantly from long-term trends, indicating potential overvaluation or bubbles. However, Thaler notes that while these analyses can indicate when markets are overheated, predicting the exact timing of market corrections remains challenging. He emphasizes the difficulty of profiting from market timing, suggesting that while it’s possible to recognize a bubble, knowing when it will burst is much harder.

Thaler discusses the peculiarities of closed-end funds in relation to the EMH, particularly challenging the notion that market prices always accurately reflect intrinsic value. Closed-end funds, unlike open-end funds, have a fixed number of shares and trade on the market, often at prices that differ from their Net Asset Value (NAV), which is a clear violation of the law of one price—a core tenet of EMH.

Thaler, along with Charles Lee and Andrei Shleifer, researched these funds and noted several puzzles: why new closed-end funds often sell at a premium but quickly trade at a discount, why discounts and premiums vary, and why discounts converge to NAV when a fund’s structure changes to open-end. They proposed these anomalies could be explained by “investor sentiment,” particularly among individual investors who dominate the closed-end fund market. Their analysis found a correlation between the average discount on closed-end funds and the performance difference between small and large company stocks, suggesting shifts in investor sentiment affected both.

This research attracted significant attention and criticism, particularly from Nobel Prize-winning economist Merton Miller. Miller, along with colleagues, wrote a critical comment on their paper, leading to a public debate. Thaler argues that despite the contention, the debate brought greater visibility to their findings and contributed to a broader discussion about anomalies in financial markets and the limits of the EMH.

Thaler examines the contradictions of the EMH, particularly focusing on the law of one price. Thaler, with colleague Owen Lamont, examines the curious case of 3Com and its subsidiary Palm, highlighting a glaring market irrationality. When 3Com announced the separation of Palm, a small percentage of Palm’s shares were sold publicly, leading to an inflated valuation of Palm’s stock. Astonishingly, the market valuation of 3Com, which still held a majority of Palm’s shares, did not reflect this inflated value. The price discrepancy suggested a negative value for 3Com’s remaining business, an impossible scenario under rational market theories.

This incident, among others like the Royal Dutch Shell stock anomaly, illustrates the market’s failure to adhere to the law of one price, contradicting a fundamental principle of EMH. Thaler likens these market irregularities to “fruit flies” in genetics—minor but crucial subjects for study, revealing deeper systemic issues. He argues these examples are just the tip of the iceberg, indicative of larger market mispricing.

Thaler contends that while EMH provides a useful normative benchmark, it falls short as a descriptive model of financial markets. He acknowledges the partial truth in the no-free-lunch component of EMH but is critical of the price-is-right component, noting significant deviations in stock market values from intrinsic values. Thaler concludes that market prices can often be significantly wrong, leading to substantial resource misallocation, as evidenced by the housing market bubble. He suggests policymakers should recognize the possibility of market bubbles and take preventive measures, rather than adhering rigidly to the belief that markets are always efficient.