Before Behavioral Finance - Wall Street Folklore and Value Investing
Before behavioral finance became a real academic field, people already knew something was off with markets. Traders in the 1920s had their own rules. Value investors in the 1930s had theirs. And nobody was waiting for professors to tell them the market was irrational. They lived it every day.
Chapter 3 of Burton and Shah’s book is about these forerunners. The people and ideas that came before behavioral finance had a name. And honestly, some of the best insights are almost a century old.
1987: The Year That Broke the Efficient Market Story
Let’s start with a story. The year is 1987. The Dow Jones starts the year around 2,200. And it ends the year… also around 2,200. If you went to sleep in January and woke up in December, you’d think nothing happened. Boring year, right?
Wrong. In between, the market rallied 30 percent in the first half. Then on October 19, 1987, it dropped 22 percent in a single day. That’s 509 points gone. The worst single-day percentage loss in U.S. stock market history at that point.
Here’s the thing. Nobody could explain why. The Wall Street Journal ran a special edition the next day and asked top executives from the biggest firms what happened. Their answers were all over the place. No consensus. No agreement. These people talked to each other every day, drank at the same bars, and they still couldn’t agree on what just happened.
If the efficient market hypothesis was correct, prices should move because of new information. But what information caused a 30 percent rally followed by a 22 percent crash in the same year? Nobody had a good answer.
This was the kind of event that made academics start questioning the efficient market story. But traders? Traders already knew markets were weird. They’d known it for decades.
The Folklore of Wall Street Traders
The first big bull market in U.S. stocks happened in the 1920s. This was also the first time regular people, not just professionals, started trading stocks. And with all that activity came trading folklore. Rules of thumb. Street wisdom. The kind of stuff old traders would pass to younger ones.
The most famous book from this era is Reminiscences of a Stock Operator by Edwin Lefevre, published in 1923. It’s based on a real trader named Jesse Livermore, known as the “Boy Plunger.” The book describes short selling, short squeezes, and all kinds of speculative strategies. Some of those strategies actually became illegal after the reforms of the 1930s.
But the interesting part for us is this: the book’s core message was that you can beat the market by understanding how people feel. Emotional sentiment, crowd behavior, fear and greed. Sound familiar? That’s basically behavioral finance, just without the academic papers.
And it wasn’t just traders thinking this way. Even big-name economists were in on it. Irving Fisher, a famous Yale economist, published a book in 1929 saying stocks would probably never go down again. Great timing on that one. And John Maynard Keynes, one of the most well-known economists in history, was actively speculating in currency and stock markets during the 1920s. Keynes later wrote about markets being driven by “waves of pessimism and optimism.”
So both traders and economists acted as if markets were predictable. Nobody was talking about efficient markets yet. That theory came later. But the people actually in the markets already behaved like behavioral finance was common sense.
Two Trading Strategies That Still Matter
From all this trader folklore, two big strategies emerged. And here’s the funny part: they kind of contradict each other.
Strategy 1: Momentum. If a stock is going up, it will keep going up. Jump on. Ride the wave. This works in the short term. Stocks that are trending tend to keep trending for a while.
Strategy 2: Mean reversion. If a stock has been going up for a long time and everyone loves it, get out. Because eventually it will come back down to normal. This works in the long term. What goes up eventually comes back.
So in the short run, follow the trend. In the long run, bet against the trend. Traders in the 1920s knew this. Academic researchers only started testing these ideas with real data 60 or 70 years later. And guess what? The data supported both strategies. Momentum works short-term. Mean reversion works long-term. The traders were right all along.
Graham and Dodd: The Birth of Value Investing
In 1934, two business school professors, Benjamin Graham and David Dodd, published Security Analysis. This book changed everything.
The timing was perfect. The Securities Acts of 1933 and 1934 had just forced all public companies to publish detailed financial statements every quarter. So for the first time, regular investors had access to real numbers. Revenue, expenses, assets, liabilities. All of it, every three months.
Graham and Dodd said something simple but powerful: stop treating the stock market like a horse race. Instead, study the actual financial statements. Find companies where the stock price is lower than what the company is actually worth. Buy those. That’s value investing.
Their message was clear. Don’t buy the stocks everyone else is excited about. Buy the ones everyone is ignoring. Look for diamonds in the rough. Find the company with solid fundamentals that the market has beaten down because of short-term bad news.
Warren Buffett is probably the most famous follower of Graham and Dodd. He studied under Graham and built his entire investment philosophy on this approach.
And here’s what’s interesting for behavioral finance. Value investing is basically mean reversion applied to individual stocks. It says the market overreacts to bad news. People get emotional, they dump stocks, and prices fall below true value. A patient, rational investor can profit from that overreaction.
So again, the core idea is that markets are not perfectly efficient. Prices can be wrong. And if you’re disciplined enough, you can find the mistakes.
In 1992, two economists named Eugene Fama and Kenneth French published research that seemed to confirm value investing actually works. The data showed that buying cheap, overlooked stocks and holding them really did beat the market over time. Graham and Dodd were vindicated by the numbers.
Financial News: The Noise Machine
Now fast forward to the modern era. TV, internet, 24/7 financial news. CNBC. Bloomberg. Twitter. Reddit. An endless stream of information about every stock, every index, every economic report.
But here’s the thing. Most of what financial news reports is not actual new information. It’s opinion. It’s analysis of facts that everyone already knows. It’s noise.
Burton and Shah use this word deliberately. Noise. Because in finance, noise is the opposite of real information. Real information is something the market doesn’t know yet. Noise is everything else. And most financial news is noise.
Think about all the stuff you hear. “Year-end rally expected.” “Support level at 4,500.” “Resistance at 5,000.” A rational investor would have zero interest in these concepts. They have no connection to the actual value of companies. But people listen. And people trade based on this stuff.
When you buy or sell a stock because a TV personality said something that sounded smart, you’re a noise trader. You’re not trading on real information. You’re trading on someone’s opinion about already-public facts. And this is one of the key ideas in behavioral finance. A lot of market activity comes from noise, not signal.
Why This History Matters
Chapter 3 is short but important. It shows that long before behavioral finance became a formal academic field, the ideas were already out there. Traders in the 1920s knew about momentum and mean reversion. Graham and Dodd knew markets overreact. Keynes knew about waves of optimism and pessimism.
The efficient market hypothesis came along in the 1960s and 1970s and basically said all these people were wrong. Markets are efficient. You can’t beat them. Prices are always right.
But then 1987 happened. And the academic world started to listen to what traders and value investors had been saying for decades. Markets are made of people. People are emotional. And emotions move prices.
That’s the foundation that behavioral finance was built on. Not some brand new discovery. Just old wisdom that finally got the academic treatment it deserved.
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