We have written a great deal about the debate between active and passive money management, and the topic is now getting attention from the broader financial media. A recent front-page article in the Wall Street Journal (October 18, 2004 “As Two Economists Debate the Markets, The Tide Shifts” ) provided a summary of the debate, led by Eugene Fama Sr., proponent of the efficient market view, and Richard Thaler, who supports a behaviorist explanation of the workings of capital markets.

The efficient-market hypothesis posits that markets quickly digest information and provide the best estimate of a firm’s economic value, so that trying to consistently beat the market is futile. Behaviorists, on the other hand assert that investors’ collective behavior is not always rational, so that irrational pricing results, along with possible opportunities for investors to “beat the market.”

The behaviorist view has apparently gained ground, but this momentum appears largely to be driven by anecdotal evidence. Behaviorists point to apparent market timing and stock picking anomalies, such as the run up and subsequent collapse of tech stocks in early 2000, and the price of Palm Inc., which after its initial offering was almost double the market value of it’s parent 3Com, despite the fact that 3Com held all but 6 percent of Palm’s shares. But to simply accept irrational pricing as an explanation for these events would be a rejection of the notion that investors expect an appropriate level of return for the risk they assume. That in turn would force us to throw out all we think we know about a firm’s cost of capital. The job of an economist as a social scientist is to seek explanations of phenomena that are consistent what we think we know to be true. We should not throw out fundamental tenets about the way markets work simply because we are faced with an apparent inconsistency.

While we find the academic wrangling to be interesting, what we care about most at the end of the day is how to invest wisely. To address that question, we skip to the last paragraph of the article. There Professor Thaler admits that rather than trying to identify mispriced assets he invests his own savings in index funds. The fact is, market anomalies exist and they deserve closer scrutiny, but thus far behaviorists are not even close to offering a substitute framework for modern portfolio theory as the basis for investing wisely.

Also in This Issue:

Quarterly Review of Investment Policy
Smart Tax Strategies
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield