Managing investments in emotionally charged markets: A behavioral framework

Published on Proactive Advisor Magazine May 6, 2020

Is it time to move away from the efficient market hypothesis to a more realistic representation of markets? Viewing stakeholders as emotional decision-makers, rather than rational computational entities, will help in navigating a changing financial environment.

“Indeed, we have to distance ourselves from the presumption that financial markets always work well and that price changes always reflect genuine information. … The challenge for economists is to make this reality a better part of their models.”

— Robert Shiller, “From Efficient Markets Theory to Behavioral Finance”

Professor Shiller wrote these words in 2003. But he could just as easily have written them today in light of the recent wild swings in the stock market.

The prevailing theory of efficient markets assumes that stock prices reflect a company’s valuation, but activity over the last couple of months clearly demonstrates the role that emotions play in buy and sell decisions. Eventually, these highly charged emotions will dissipate as solutions to the coronavirus-induced lifestyle are introduced. The impact of behaviors on market activity, however, will not subside. They are present in everyday trading patterns. This article provides a framework for viewing the behaviorally driven decisions so commonly made by investors.

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