I must confess that I was a skeptic on behavioral finance until a few years ago. At that point, the amount of information that had been accumulated on the "irrational" behavior of investors became so overwhelming that I faced one of two choices. I could ignore reality and live in the clean, rational world of classical economics or I could face up to facts and think about how investment and corporate finance decisions should be made in the messy world that we live in. After struggling with the conflict, I think I am making some progress. In an earlier post on the third edition of my corporate finance book, I noted my attempts to incorporate the findings from behavioral finance into every aspect of corporate finance from how to create effective boards of directors to capital budgeting and capital structure decisions.
Reconciling behavioral finance with my view of the world has been tougher in my other area of interest: valuation. Every semester that I teach the valuation class, using the tools of the trade (discounted cash flow models, relative valuation), I am asked how I would incorporate the findings from behavioral finance into valuation. Here is my reaction. I don't think intrinsic valuation approaches will change much, if at all, as a result of behavioral economics. The expected cash flows are still the expected cash flows and the required return still has to reflect the perceived risk in the investment.
So, what does change? Remember that to make money of your valuations, not only do you have to be able to value assets but the price has to move towards that value. Behavioral economics provides us with interesting insights on three dimensions:
a. Why do different analysts arrive at different estimates of value for the same company? When you value a company, you are one of many doing so, often drawing on the same information as other investors, and often using the same models. So why do different analysts arrive at different estimates of value? By looking at the interaction between psychology and valuation, behavioral economics yields interesting insights into why the values that we arrive at are different (and by extension, why some of us are buyers and others are sellers) and the systematic errors (over valuation or under valuation) that we make as a consequence.
b. Why does price differs from value? In the classical world, the price can deviate from value because investors make mistakes or because the price may reflect information that the analyst may not have or vice versa. With behavioral economics, we are learning that even if investors may behave in ways (refusing to sell losers, wanting to be part of the crowd, being over confident and misassessing probabilities) that cause prices to diverge from value by significant amounts.
c. When will they converge? Behavioral economics may provide us with clues about how quickly convergence between price and value will happen and why the speed may vary across assets. That would be incredibly useful to an investor. Thus, we may be able to answer a question that has historically eluded us: If I buy a cheap stock today (and I am right about it being cheap), how long do I have to wait before my bet pays off?
As investors, it behooves us to not only become conversant with the findings in behavioral finance but to also recognize when following instinct can damage portfolios. Meir Statman, one of my favorite behavioral economists, has written a great book on how investors can overcome their base urges and make better decisions:
http://www.amazon.com/What-Investors-Really-Want-Financial/dp/0071741658/ref=ntt_at_ep_dpi_1
I hope you get a chance to read it. There is much work to be done, but the foundations are being laid.
Reconciling behavioral finance with my view of the world has been tougher in my other area of interest: valuation. Every semester that I teach the valuation class, using the tools of the trade (discounted cash flow models, relative valuation), I am asked how I would incorporate the findings from behavioral finance into valuation. Here is my reaction. I don't think intrinsic valuation approaches will change much, if at all, as a result of behavioral economics. The expected cash flows are still the expected cash flows and the required return still has to reflect the perceived risk in the investment.
So, what does change? Remember that to make money of your valuations, not only do you have to be able to value assets but the price has to move towards that value. Behavioral economics provides us with interesting insights on three dimensions:
a. Why do different analysts arrive at different estimates of value for the same company? When you value a company, you are one of many doing so, often drawing on the same information as other investors, and often using the same models. So why do different analysts arrive at different estimates of value? By looking at the interaction between psychology and valuation, behavioral economics yields interesting insights into why the values that we arrive at are different (and by extension, why some of us are buyers and others are sellers) and the systematic errors (over valuation or under valuation) that we make as a consequence.
b. Why does price differs from value? In the classical world, the price can deviate from value because investors make mistakes or because the price may reflect information that the analyst may not have or vice versa. With behavioral economics, we are learning that even if investors may behave in ways (refusing to sell losers, wanting to be part of the crowd, being over confident and misassessing probabilities) that cause prices to diverge from value by significant amounts.
c. When will they converge? Behavioral economics may provide us with clues about how quickly convergence between price and value will happen and why the speed may vary across assets. That would be incredibly useful to an investor. Thus, we may be able to answer a question that has historically eluded us: If I buy a cheap stock today (and I am right about it being cheap), how long do I have to wait before my bet pays off?
As investors, it behooves us to not only become conversant with the findings in behavioral finance but to also recognize when following instinct can damage portfolios. Meir Statman, one of my favorite behavioral economists, has written a great book on how investors can overcome their base urges and make better decisions:
http://www.amazon.com/What-Investors-Really-Want-Financial/dp/0071741658/ref=ntt_at_ep_dpi_1
I hope you get a chance to read it. There is much work to be done, but the foundations are being laid.
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