Landmarks in the Theory of Financial Markets

A Paradigm Shift: “From Efficient Markets to Behavioral Finance”. Since the 1990s a new school of thought emerged whose main views are in sharp contrast with those of the Efficient Market Hypothesis. This new paradigm, usually referred to as Behavioral Finance, acknowledges that psychological factors play a key role in investors’ decision making pro-cess. Instead of assuming that investors are fully rational in the sense of processing information accurately and instantaneously, the advocates of behavioral finance, such as the psychologists Daniel Kahneman and Amos Tversky as well as the economists Werner DeBondt and Richard Thaler, put forward the idea that investors commit several cognitive errors in making investment decisions. These errors are numerous including over-reaction, over-confidence, … All these errors are grouped under the title “investors’ fallacies”. The net effect of these fallacies is that current stock prices may be quite imprecise, meaning that they deviate persistently from the corresponding fair prices.

Implications for Asset Management: If markets are not efficient then prices might not fluctuate randomly. Investors’ fallacies, if properly studied and understood, may reveal predictable elements in market’s behavior which in turn may produce predictable patterns in stock returns. Whoever succeeds in identifying those patterns acquires a significant edge over the rest of the market which in turn is likely to enable him to systematically beat the market. Active portfolio management may prove to be a worthwhile and lucrative endeavour.