Behavioral Finance

CHAPTER 3

The Forerunners to Behavioral Finance

Academics were reasonably content with the efficient market hypothesis (EMH) until sometime toward the end of the twentieth century. The year 1987 was critical in undermining faith in the EMH. U.S. stock market behavior in 1987 was bizarre. The year began with the Dow Jones Industrial Average at slightly above 2,200, and it ended the year in that general area. If all you knew were the beginning and ending stock market averages, then 1987 would seem to be a ho-hum type of year. But in between the beginning and ending averages, there was an incredible rally and a historic collapse. The market's behavior can be summarized in Figure 3.1.

Figure 3.1 Summary of Market Behavior

The interesting question about 1987's stock market performance is: why? What news and information were there that led to a 30 percent rally in the first half of the year, followed by October 19, 1987, the worst single-day percentage loss in U.S. equity market history? The year 1987 should be called the “Rip Van Winkle” year. If you fell asleep in early January and awoke in late December, you would not know that much of anything had happened.

When you ask observers what happened to cause the big rally and big decline, almost everyone will provide an answer, especially those who consider themselves savvy about financial markets. But the answers are all over the map, ...