Is
Investing an Art or a Science?
Do you
believe that stock prices behave rationally, according to all available
information? Or do you think they are influenced by fear, greed, and other
emotions?
Whether you view the markets as emotional or rational may have an impact on the
way you invest. By factoring in your belief system when making or adjusting your
financial strategy, you may be more likely to stick to your plan when moments of
uncertainty arise.
Efficient Market Theory
Developed in the late 1960s, the efficient market theory contends that market
prices correctly reflect all information available to investors. This means that
what is known about a stock is already reflected in the price, so stock prices
only fluctuate in reaction to new information.1
Efficient
market theorists believe it is impossible to beat the market without inside
information (or incredible luck) because the market is always right and because
future fluctuations are based on future information, which cannot be foreseen.
The best strategies an investor can follow are to “buy and hold” and
diversify, trusting that despite temporary fluctuations, stock prices will rise
over time as earnings increase.
Behavioral Finance
During the 1990s, an opposing school of thought, called behavioral finance,
challenged the efficient market theory. Behavioral economists argue that markets
cannot be entirely rational because investors are inherently irrational and
emotional, especially when it comes to money. They cite the “irrational
exuberance” of the late 1990s, followed by the ensuing bear market, as just
one indication that stock prices are at least partly driven by investor greed
and fear.
Behavioralists believe that future movements in the stock market may be
predicted by studying past investor behavior. As a result, they contend that
detailed analysis and careful discipline may enable investors to outperform the
stock market. Yet those attempting to do so may be hampered by the same emotions
that drive investors as a whole to make irrational decisions. Thus, many of
those who support the behavioralist doctrine still advocate long-term investing
and diversification.
Though most economists admit there is some truth in both of these theories, the
question of what drives market fluctuations is still up for debate. Whatever
side of the line you’re on, sticking to a financial program that reflects your
core views may help you act rationally, even when the market doesn’t.
1) The return and principal value of stocks fluctuate with
changes in market conditions. Shares, when sold, may be worth more or less than
their original cost.
© 2003
Emerald Publications
