The End of Behavioral Finance

n 1985, Werner De Bondt and I published an article that asked the question: “Does the stock market overreact?” The article was controversial because it gave evidence to support the hypothesis that a cognitive bias (investor overreaction to a long series of bad news) could produce predictable mispricing of stocks traded on the NYSE. Although this idea was hardly shocking to practitioners, the conventional wisdom among finance academics was that we must have made a mistake somewhere. The academic community considered several possibilities to explain our results: We made a programming error; the results were correctly measured but explainable by chance variation (data mining); the results were correct and robust (no data mining), but rather than discovering mispricing caused by cognitive errors, we discovered some new risk factor. The possibility that we had both the facts and the explanation right was thought by many academics to be a logical impossibility, and the demise of behavioral finance was considered a sure bet. Fifteen years later, many respectable financial economists work in the field called behavioral finance.1 I believe the area no longer merits the adjective “controversial.” Indeed, behavioral finance is simply a moderate, agnostic approach to studying financial markets. Nevertheless, I too predict the end of the behavioral finance field, although not for the reasons originally proposed. To understand what behavioral finance is and why it was originally thought to be a fleeting heresy, one must first understand the standard approach to financial economics and why those who used this approach believed, on theoretical grounds, that cognitive biases could not affect asset prices.