Market efficiency vs. Behavioral Finance: Which Strategy Offers Better Returns?

By Scott Lanigan, CFA

I’m the most important person in behavioral finance, because most of behavioral finance is just the critique of efficient markets. So without me what do they have?

Eugen Fama

Gene has it all wrong If it hadn’t been for Behavioral Finance, he and French would have had nothing to do for the past 25 years. He owes me everything.

Richard Thaler

After reading these quotes from Fama and Thaler, you can conclude that they are fierce rivals. But this is far from the case. Fama and Thaler are business school professors at the University of Chicago and well-documented golf buddies. But despite the occasional sharing of 18 holes, there is a very real underlying tension between the two. Fama is the captain of Team Efficient Markets and Thaler is the captain of Team Behavioral Finance. Each represents the conflicting philosophies of the academic market which they have been at war for years. It’s the academic equivalent of Lakers vs. Celtics.

Team Efficient Markets believes that market prices reflect all available information and are therefore efficient. Its strongest proponents believe that risk-adjusted performance over long time horizons is not possible. Over time, the philosophy has expanded to include risk factors. Investors can be compensated by tilting their portfolios towards risk factors to achieve higher returns. This team believes that because these factor tilts represent an increased risk, risk adjusted performance over long periods of time is not possible.

Proponents of market efficiency argue that if empirical evidence shows that long-term risk-adjusted performance has been achieved, investors have achieved it not by skill but by biasing portfolios towards a previously unidentified risk factor or by bad luck. “Buffett’s Alpha” deconstructed Warren Buffett’s phenomenal track record at Berkshire Hathaway (BRK.A, BRK.B) into various explanatory factors. The paper won the Graham and Dodd Award for Best Paper in 2018. The award recognizes excellence in financial research and writing in Journal of Financial Analysts. Although the authors acknowledged that Buffett’s record was not due to luck, it is hard to read the paper without getting the feeling that its purpose was to knock Buffett’s performance down.

Team Behavioral Finance, on the other hand, believes that market prices reflect all available information most of the time, but that market participants are also influenced by behavioral biases. This behavior leads to market inefficiencies that can be exploited to achieve risk-adjusted outperformance, even over long time horizons. In terms of factor investing, the behavioral camp believes that “risk factors” represent price/value differences due to behavioral biases rather than an increase in risk taking. As for Buffett, this camp is more likely to believe that his track record is due to his equal decision-making skills and access to unique sources of information.

Unfortunately, many problems arise when debating market anomalies. The two main problems stem from the difficulties of hypothesis testing (eg, how would you test for behavioral biases?) and the subjective interpretation required when a market anomaly is discovered (eg, increased risk, behavioral inefficiency, or spurious correlation).

But fortunately, the respective philosophies of Fama and Thaler strongly influence two major asset management firms, Dimensional Fund Advisors (DFA) and Fuller & Thaler Asset Management (FullerThaler).

DFA founder David Booth served as a research assistant at Fama while attending the University of Chicago in 1969. The firm’s investments are heavily based on Fama’s academic research, which led it to lean portfolios to small, inexpensive companies with higher than average profitability. Fama is also a director and consultant at DFA.

As the name suggests, Thaler co-founded FullerThaler with Russell Fuller. The firm tries to exploit behavioral biases to outperform markets. Like DFA, the firm tilts its portfolios toward value and size factors. Unlike DFA, the firm seeks to exploit loss aversion bias, believing that investors overreact to bad news and losses and underreact to good news. As the name suggests, Thaler co-founded FullerThaler with Russell Fuller. The firm tries to exploit behavioral biases to outperform markets. Like DFA, the firm tilts its portfolios toward value and size factors. Unlike DFA, the firm seeks to exploit behavioral biases, believing that investors overreact to bad news and losses and underreact to good news.

Both firms have an investment fund with a long history and the same benchmark, The Russell 2000 Value Index. Figure 1 pits the competing philosophies against each other and benchmarks the funds.

Figure 1. DFA US Small Cap Value Portfolio (DFSVX), FullerThaler Undiscovered Managers Behavioral Value Fund (UBVLX) and Russell 2000 Value Index.

Team Behavioral Finance outperformed Team Efficient Markets by 0.91% annually between December 1998 and July 25, 2024. But many readers may not agree that this proves Team Behavioral Finance’s victory because the results do not take into account the risk taken . Fair enough. To test this, we applied Jensen’s alpha (ALPHA) and used only the Russell 2000 stock index as a benchmark. For the risk-free rate, we have annualized the three-month Treasury rate.

Figure 2.

After factoring in risk, Team Behavior still comes out on top. This is almost unanimously confirmed in all risk-adjusted return metrics as shown below, apart from the information ratio.

Despite results suggesting that investors can exploit behavioral biases, even over long time horizons, strong believers in market efficiency may be hesitant to change their minds. If so, I encourage these individuals to check their own behavioral biases to ensure that they exhibit the same rational traits that the market efficiency hypothesis assumes to be true.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute.

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Editor’s note: The abstracts for this article were chosen by the editors of Seeking Alpha.