How does Efficient Market Account for Fear, Greed and Risk Taking?

In the last decade we have endured a number of market bubbles ending in catastrophic losses for investors and bankruptcy for more than a few corporations.  In the Efficient Market world, all securities are priced, or discounted to their exact and correct price because investors are rational, and can take into consideration all known information about the security,  and thus price it accurately.  We can throwEfficient Market Theory’s unnatural spawn into the mix, the Capital Asset Pricing Model which is assumes investors and investments are the result of rational thought.

If the market is pricing everything accurately, how in the world can we find ourselves in markets grossly overbought or oversold?  According to the Efficient Market cabal, arbitrage takes up the slack, or spurious mispricing that occasionally occurs with the utmost efficiency.  If everything is price accurataely, how can we then find ourselves in a price bubble?  And for the record, I think we are presently in a overbought market and stock values may be bid higher than the ought to be priced.

I’ll tell you the problem, to my way of thinking.  In Efficiently Market Theory, freshwater economists assume that investors are rational in their buying of securities.

In my world, a non-efficient world, stock prices are driven by greed, fear and risk assessment, or speculation, and there is nothing remotely rational about any of those three attributes.   If investors were not greedy, why not just invest in some short term Federal bonds and enjoy their smaller earnings?  Why risk their capital in the stock market, where they stand a chance to lose more and make more?   Of that’s easy isn’t it?  Greed.   People are not happy with the paltry returns on savings accounts or short term Treasuries...they want more and are willing to take on some risk in order to earn more money.  And they seldom fully understand the risk they are taking.

On the other hand, fear is an even more intriguing investing emotion.   Last fall and early this year we had a catastrophic plunge in the stock market.  We don’t need to discuss the reasons why this happened, as the facts are well documented.   Many of my friends hung in their 401(k) mutual funds until the market nearly bottomed and then exited, fearing they were in danger of losing all of their money.  It’s the old buy high and sell low syndrome...their fear got the better of them.   Any rational investor would look at a 50 or 60% drop in the market, assuming they had not gotten out early, and think “what’s the use in getting out now.”   The damage is done.  Yet careful study of market collapses or crashes shows the small investor hangs in till the end, then sells.

Speculators simply assess risk, usually through probability, and trade where the opportunity seems best to make money and then bank their profits.  Many speculators depend very heavily on technical analysis, which is something akin to a mortal sin to an Efficient Market Theorist.  Yet us scalpers and speculators continue to make money on a system that academia says cannot exist because there are few pricing anomalies in the market.  

In my world fear, greed and risk are the prime movers in price action, and Efficient Market Theory has no real contingencies for these emotional responses in explaining market movement,  and every time a price bubble forms the Efficient Market Theory climbs one notch lower on the ladder.