From Ef cient Markets Theory to Behavioral Finance

A cademic Ž nance has evolved a long way from the days when the efŽ cient markets theory was widely considered to be proved beyond doubt. Behavioral Ž nance—that is, Ž nance from a broader social science perspective including psychology and sociology—is now one of the most vital research programs, and it stands in sharp contradiction to much of efŽ cient markets theory. The efŽ cient markets theory reached its height of dominance in academic circles around the 1970s. At that time, the rational expectations revolution in economic theory was in its Ž rst blush of enthusiasm, a fresh new idea that occupied the center of attention. The idea that speculative asset prices such as stock prices always incorporate the best information about fundamental values and that prices change only because of good, sensible information meshed very well with theoretical trends of the time. Prominent Ž nance models of the 1970s related speculative asset prices to economic fundamentals, using rational expectations to tie together Ž nance and the entire economy in one elegant theory. For example, Robert Merton published “An Intertemporal Capital Asset Pricing Model” in 1973, which showed how to generalize the capital asset pricing model to a comprehensive intertemporal general equilibrium model. Robert Lucas published “Asset Prices in an Exchange Economy” in 1978, which showed that in a rational expectations general equilibrium, rational asset prices may have a forecastable element that is related to the forecastability of consumption. Douglas Breeden published his theory of “consumption betas” in 1979, where a stock’s beta (which measures the sensitivity of its return compared to some index) was determined by the correlation