Jun 1, 2006 12:00 PM

, By Patricia Stewart, managing director, JPMorgan Private Bank, New York

By Patricia Stewart, managing director, JPMorgan Private Bank, New York

One of the pillars of modern portfolio theory is the efficient market hypothesis (EMH), a theoretical framework for understanding how securities are valued in the marketplace. According to the EMH, the market is composed of well-informed and rational investors simultaneously making decisions that drive assets to their true value.

Competing theories and volumes of research suggest, however, that the market is driven by other forces as well — among them, the irrational behavior of investors acting upon persistent biases in their perceptions. These biases may create anomalies in the marketplace that astute investors can exploit to their advantage. This is what people refer to as “behavioral finance.”