VideoCapital markets are not efficient.
Analysts will recommend a stock simply because other analysts have, and investors will buy a stock because other investors have — they're running with the herd. A division manager will act in ways designed to bolster his reputation first, rather than increase the value of the firm's assets.
No, this isn't what you learned in business school, but it is what's being taught there now. These are a few of the big ideas being vigorously researched and heatedly discussed by some of the brightest minds in academe. They represent a sea change in the way that questions in finance are being framed — away from the idea that markets and individuals always act rationally and toward a less rational and more psychologically rooted understanding of how managers, investors, analysts, and, ultimately, the markets they create will act.
To get a grip on how the theory of finance is changing and where it is heading, CFO magazine recently interviewed some of the leading thinkers in the field. None of the seven theorists we spoke with are Nobel laureates, though several are assumed to be in the running for that honor. Some have contributed to the literature for decades, while others have recently arrived on the scene. Not all of them work strictly within the discipline of corporate finance; some have made their reputations in investment theory or asset pricing. Each theorist has his specialty or two, which tend to color his view of what the major unsolved problems in corporate finance are.
All are the intellectual heirs of such giants as Modigliani, Miller, Black, Sharpe, and Markowitz. But while they readily acknowledge their debt, these finance theorists have new and even startling views of what the future may hold.
Ivo Welch: Following the Herd
So what's the state of finance theory today, and where is it heading? "A good analogy is physics," responds Ivo Welch, professor of finance at Yale University's School of Management. "The old mechanical physics is like the efficient-markets theory. It gives a good first-order explanation of how the apple falls from the tree and hits the scholar on the head. Then, as with Einstein, everything is suddenly different. The puzzles are on scales we hadn't observed before." Welch pauses, then adds, "The good thing is that in finance we don't have to build [particle] supercolliders."
At 37, Welch is considered a rising star in finance theory. His research focuses on the pricing of initial public offerings, capital structure, and informational cascades, a branch of theory that attempts to explain herding in financial markets. The latter is "still a first-order problem," says Welch, who cites the recent drop in Internet stocks as an example. Why do some sectors of the economy fall into or out of favor? "Herding is the phenomenon that drives this," answers Welch. "Investors believe they learn from each other." Analysts and investors alike flock together to create a prevailing consensus; the safety of numbers overrides individual doubts. But when the herd changes direction, investors can get hurt. "Lots of hedge funds went bankrupt because they thought Internet funds wouldn't go down," notes Welch.
Another issue that fascinates Welch is what drives the internal allocation of capital in corporations. "We have wonderful theories telling us which division should get capital," he explains. "But to what extent is the personality of a division manager playing a role in getting capital, and to what extent does this explain the failures or successes of a particular division? Personality may be a great predictor."
Generally, Welch views the internal workings of corporations as a fertile field for finance theorists. "Even with good description on capital budgeting, we don't systematically know how the capital budget works in corporations," he says. "We don't know best practices." The latter will come as more and more internal information is revealed to academics who advise the corporations, predicts Welch. "Usually it's tit for tat," he says. "They'll give us the data, and we'll tell them later what the best practices are."
Robert Shiller: Missing Markets
The study of herding phenomena in capital markets falls under the aegis of what has come to be known as behavioral finance, a controversial discipline that took root in the 1990s. "It's a theory of finance that doesn't want to rationalize human behavior," explains Robert Shiller, who at age 54 is regarded as one of the godfathers of the field. The simple proposition that investors are swayed by psychological and sociological factors is radically subversive, since it undermines the dogma that capital markets are efficient. Heretical as this point of view seems today, it was commonsensical prior to the advent of the efficient-markets hypothesis in the 1960s and 1970s, points out Shiller, the Stanley B. Resor Professor of Economics at Yale University.
Shiller became something of a media figure with the publication last March of his book on the state of the stock market, Irrational Exuberance, and he has written several op-ed pieces on the dangers of what he sees as the enormous speculative bubble in the market. But as an economist, Shiller also sees the power of markets to do good, especially by enabling investors to hedge risks. To that end, he has become a prominent advocate for the creation of more markets — specifically, "macro markets."
Reader Comments» Post a comment