Is the market rational

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Tuesday, December 3, 2002

Is the Market Rational?

No, say the experts. But neither are you--so don't go thinking you can outsmart it.

By Justin Fox

Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control--costs--and keep them as low as possible. Today that is pretty standard, if often unheeded, investmentadvice. Forty years ago it was revolutionary. The revolution started on college campuses, in particular at the University of Chicago, and it went by the unrevolutionary-sounding name "efficient markets."
"In an efficient market," wrote Chicago professor Eugene Fama in a landmark paper he delivered at the 1969 annual meeting of the American Finance Association, "prices 'fully reflect' availableinformation." That is, in an efficient market you can't beat the market unless you have inside information. So why bother trying?

That logic led, among other things, to the creation of index funds that aim to mimic, not beat, the likes of the S&P 500 and the Wilshire 5000. Today such funds account for about 10% of total U.S. stock market capitalization, as well as 60% of what little money hasflowed into equity mutual funds so far this year. But millions of small investors have continued to ignore the advice derived from efficient-markets theory, preferring instead to trade stocks and pile in and out of mutual funds in search of elusive market-beating returns (blowing much of their money on fees and commissions in the process).
Meanwhile, back on campus, a new generation of financeprofessors has been ripping Fama's teachings to shreds. The organizing principle for this new breed of scholars is not efficient markets but something called behavioral finance. Behavioral finance teaches that stock market investors are irrational, that future stock price movements are at least partly predictable from past behavior, and that careful analysis of past trends and financial reports canpay off. Which happens to be the way most investors see the market already.
Over the next few pages we're going to take you on a journey through the academic battles that have brought us to this point. This is FORTUNE's annual Investor Guide, not The Chronicle of Higher Education, so we wouldn't tell this story if we didn't think it had relevance for investors battered by the experience of thepast few years. The message that the behavioral finance guys have for investors is that yes, you can beat the market, but--for reasons that are essential to the whole behavioralist case--you almost certainly won't. As a result, they end up offering much of the same investment advice that the efficient markets folks do. Only this time we might actually listen.
Gene Fama, it must be said, doesn'tbuy any of this. It's a cold, gray mid-autumn day in Chicago, but Fama is wearing a loud shirt with too-short sleeves that prove him to be probably the buffest 63-year-old finance professor on the planet. With the hint of a Boston accent that remains after two-thirds of a lifetime in Chicago, he's talking the academic version of trash. "I don't know that it's progressed much beyond the level ofcuriosity items," Fama says of the research done by the behavioralists. "They've got lots of interesting curiosity items."
For years Fama was more than tolerant of this search for "curiosity items." Unlike his longtime Chicago colleague Merton Miller, who saw the behavioralists' work as an ideological assault on free markets (Miller died in 2000), Fama always encouraged empirical research, evenresearch that revealed seemingly inefficient market behavior. In a 1991 sequel to his famous "Efficient Capital Markets" paper of 1969, he acknowledged that reality had in fact turned out a lot messier than he and other efficient-markets theorists had envisioned--although not so messy that the theories couldn't accommodate it.
In 1997, though, Fama wrote still another paper, one that argued that...
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