The head and the heart both play a role in all areas of human decision making, including investment. While some people may be led by their intellects, and others more by their emotions, it is important to give both their due.

It can be limiting to be led by intellect only. For example, the efficient market hypothesis (EMH), which claims that all new information is immediately reflected in prices (making it impossible to generate excess returns) is an apparently simple theory that offers a neat intellectual solution and appeals to the heads of many. The EMH flatters the intellect by fitting in with neo-classical economic theories about rational decision makers who maximise utility and cause prices to be in equilibrium. The EMH has done much to drive growth in passive investing.

We have always felt the EMH to be a little too neat to be plausible. Over recent decades, some academics have argued that markets are inefficient, for example because of investor behaviour, which is not always rational 1. In the real world, prices stray far from equilibrium — think about bubbles and crashes.

One reason why markets may be inefficient is greed and fear, those twin monsters of the heart. Ruled by greed, investors may cash in winning stocks; and they may cling onto losing stocks for fear of realising a loss. The behaviour of cashing in winners may, if widespread, delay the upward move of stocks that have had good news. Conversely, widespread holding onto losers may delay the downward move of stocks that have had bad news. This may explain why momentum strategies (buying stocks that have performed well and selling those that have performed badly) have often worked 2.

There are many possible causes of market inefficiencies, including: calendar effects, which could be caused by investors rebalancing; stocks followed by fewer analysts trading less in line with fundamentals; market illiquidity, market frictions, and slow or imperfect diffusion of information. Some of these causes can be blamed on the vagaries of the human heart. Anchoring, framing, loss aversion, overconfidence bias, confirmation bias, and overreaction are examples of behavioural biases that can skew investor behaviour and so ma