http://www.ajc.com/business/content/business/0803/03behave.html
As an investor, are you Mr. Spock, a rational, unemotional decision-maker who weighs all the options, or Captain Kirk, who is likely to respond with his feelings in making a decision?
At first glance, Mr. Spock would seem to have the advantage and make the best judgments about which stocks to buy.
Not necessarily, say a trio of visiting scholars at the Federal Reserve Bank of Atlanta. Captain Kirk is more likely to do the right thing, they argue in a research report -- just as he did on the bridge of the Enterprise on TV's long-running "Star Trek" series.
"Though Spock fully analyzes each situation, he gets too caught up in the details," say the economists. "Emotion allows Kirk to focus and enhances his ability to make critical decisions."
Thus, another voice is added to the growing debate about investor psychology.
As a practical matter, the debate has a lot to say about whether we can expect the market to resume a solid, lengthy upturn, or continue in a prolonged period of subpar growth and investment returns.
The Atlanta Fed's foray into the discussion was written by Lucy F. Ackert, a professor at the Michael J. Coles College of Business at Kennesaw State University; Bryan K. Church, a professor at the DuPree College of Management at Georgia Tech; and Richard Deaves, a professor at the Michael C. DeGroote School of Business at McMaster University in Hamilton, Ontario.
The issue is whether investors behave rationally or irrationally in buying and selling stocks and other securities.
The prevailing theory on Wall Street, represented by Mr. Spock, is the efficient market hypothesis, or EMH. It says that investors are rational agents who act in their own self-interest and that markets are efficient -- meaning that relevant new information is immediately reflected in stock prices.
The import of the EMH for investors is that nobody has an advantage -- legally -- over anyone else in the stock market, and therefore nobody can "beat the market" in the long run.
If that's true, the prudent strategy would be to buy an index fund -- a mutual fund that invests in all the stocks of an index such as the Standard & Poor's 500. You can't beat the market that way, but you can't underperform it either.
On the other side of this debate is the so-called science of behavioral investing, which Yale professor Robert Shiller made famous three years ago in a book, "Irrational Exuberance."
That's the memorable phrase Federal Reserve Chairman Alan Greenspan uttered in a December 1996 speech when the stock market was beginning to rise rapidly -- too rapidly, he suggested, and for the wrong reasons. Was emotion ruling reason?
Shiller is said to be the economist who gave Greenspan the idea for that phrase, based on the idea that investing can be irrational, fueled by emotion and momentum rather than sober research into corporate fundamentals.
Shiller declared that the emotional state of investors was "no doubt one of the most important factors causing the bull market" that peaked in early 2000 and then collapsed.
University of Chicago professor Richard Thaler, another founder of behavioral economics, was even more blunt: "In a rational world, [the bubble in technology stocks] would never have happened."
New bubble fears
The controversy represented by the "Star Trek" characters has gotten increasing attention since the stock market collapsed in 2000.
Some Wall Street analysts believe they see fresh signs of a return of 1990s-style excessive exuberance in the stock market's current rally. Even after the recent plateauing of stock prices, the S&P 500 is up by 22.4 percent since the March 11 low.
Critics of the EMH argue that some investors trade less on information than on "noise," or stock activity caused by computerized program trading and other phenomena that do not reflect general sentiment. Noise traders may think they are trading on information when they aren't.
The Atlanta Fed scholars enter the debate with a basic observation: In essence, there's no such thing as pure reason devoid of emotion. And in those instances where it seems to exist -- as in people with brain injuries -- the absence of emotional response is an impediment to rational action.
Far from interfering with sound decision-making, they say, "emotion actually enhances an individual's ability to make rational choices."
"Perceptions encompass emotional aspects, which subsequently guide judgment and decision-making. Furthermore, theorists recognize that emotion and cognition are interdependent, rather than competing, influences," their report concluded.
Behavioral analysts look at actions such as investors who tend to hold on to losing stocks and sell their winners, just the opposite of professional investors.
These researchers have found that an investor's willingness to take a risk is guided more by fear of loss, and the accompanying pain, than the lure of gain, with its feeling of pleasure.
Willing participants
As for irrational exuberance, research firms such as Yankelovich Partners in Atlanta have found that some of the investing in the 1990s was motivated by a feeling of superiority on the part of the investor.
"There was a sensibility tied to people's exaggerated sense of control and empowerment that contributed to the willingness to participate in the market," said Yankelovich President J. Walker Smith.
Is the prevailing wind of stock market analysis about to shift toward the behaviorists?
Probably not, the Atlanta Fed scholars concluded. The efficient market hypothesis paradigm, or overview, appears secure for the time being because it continues to work as a tool for analysis.
"Though recent models explain certain aspects of financial decision-making that appear to be inconsistent with the efficient market hypothesis, financial economists are without a superior paradigm," the scholars said.
But that's not the end of it.
"While some argue that in certain situations, emotion may 'get in the way' and lead to suboptimal decision-making," they assert, "we believe that emotion is an important aspect of the human condition that can actually enhance decision-making."
Put another way, a stock market without emotion would be like "Casablanca" without "As Time Goes By."
