This isn't just an issue of how to manage money. It is also a raging debateamong finance professors. For years, the prevailing academic wisdom was thatthe stock market was highly efficient, with prices set by rationalinvestors. But lately, that notion has come under assault frombehavioralists, who argue that market movements aren't adequately explainedby traditional economic models.

No doubt about it, irrationality is on display everywhere. Why do investorstrade so much? All that buying and selling can't be rationally justified.Why do companies bother splitting their stocks, say, two for one? All itmeans is that shareholders now have twice as many shares, each with a 50%smaller claim on the company's earnings.

Why do companies pay dividends? From the standpoint of taxes, it makes farmore sense to buy back stock. Yet shares often rise after a companyannounces a dividend increase. "It doesn't look to me like markets behave asif investors are rational," says Richard Thaler, an economics professor atthe University of Chicago.

Thaler, the best-known behavioralist, is now using his insights to managemoney, including three funds for Undiscovered Managers, a Dallas fundcompany. The largest of the three, the $173 million Undiscovered ManagersBehavioral Growth Fund, has returned a cumulative 120.7% since its launchtwo years ago, compared with 55.6% for Standard & Poor's 500-stock index."Everybody agrees that there are some irrational investors out there,"Thaler says. "The controversial question is whether they set prices. Thebehavioralist line is that they do some of the time. The efficient-marketline is that prices are set by rational traders."

Not all behavioral quirks hurt market efficiency. Many investors, forinstance, are excessively self-confident. This shows up in investors'ill-advised tendency to trade too much and to bet heavily on a limitednumber of stocks.

But it also manifests itself in the huge effort made to find undervaluedstocks, says Mark Rubinstein, a finance professor at the University ofCalifornia at Berkeley. Rubinstein, a proponent of efficient markets,squared off against Thaler in a debate at a November 1999 conferenceorganized by the Berkeley Program in Finance.

"I concede that investors are overconfident," Rubinstein says. "But whatthis means is that active managers spend too much on research. It makes themarkets too efficient. It's like a gold mine where most of the gold hasalready been taken out. Occasionally, you'll find some, which will egg youon. But it's just not cost-effective to keep mining."

Thaler says the validity of behavioral economics doesn't hinge on being ableto beat the market. "It could be that stock prices were wildly irrational,but unpredictable," he says. "If so, it wouldn't be possible to make money."Indeed, even if you buy the behavioralist argument that the markets aren'tentirely efficient -- and the evidence is compelling -- that doesn't meanyou should try to beat the market.

No matter where investors stand on the academic debate, they "should behaveas if markets are efficient," argues William Sharpe, a finance professor atStanford University and a 1990 winner of the Nobel Memorial Prize inEconomic Science. "Individuals make mistakes," says Hersh Shefrin, also afinance professor at Santa Clara University. "Markets aggregate thosemistakes. But in the aggregation, the errors become smaller than those madeby individuals. As a result, if you set out to try to beat the market,you're more likely to fail than to succeed," after figuring in investmentcosts.

Even Thaler, who has turned his hand to money management, readily concedesthat beating the market isn't easy. The academic dispute doesn't translateinto very big differences in advice for individual investors," he says. "Theefficient-market guy says it's impossible for the individual investor tomake money. The behavioralist will look at the data and say most individualinvestors don't make money. So they would both give the same advice, whichis to buy and hold."

The bottom line? The behavioralists may offer some slim hope to the market'sstock jockeys. But in the end, it still makes a ton of sense to settle foraverage market results, by purchasing index funds.

-- The Wall Street Journal