Chapter 7: Rational Expectations, Efficient Markets, and the Valuation of Corporate Equities
Because financial markets are very complex, people have many irrational beliefs about them. The see investing as being little different from gambling, or believe that the complexity is a subterfuge to cover a global conspiracy, or some other species of nonsense. It's much easier to dismiss something complicated or reduce it to an aphorism than to understand it - and as a result, many people remain ignorant of financial markets. This makes them unable to leverage them to their own advantage and, in the worst of cases, makes them gullible and easy targets for the dishonest.
Financial markets are largely efficient and much fairer than many markets for physical goods. Most participants have access to the same information (whether or not the leverage it) and see the activities of other participants in real time. Instances in which the market can be rigged to advantage a specific party are rare and fairly easily detected. And while outcomes are not perfectly predictable, it is far less random than a game of roulette.
Financial markets are also democratic decision-making machines: every buyer and seller has a different opinion about what something is worth and are able to trade or refuse to trade at their own volition. A trade occurs when the buyer and seller agree on the value, and their agreement is reported to everyone else as the last price at which the item was traded, so they can consider whether they agree to trade at this same price.
As in any market, there is the constant tug-of-war between buyers who wish to pay less and sellers who wish to sell for more , which generally prevents the prices from getting too far out of line with a reasonable standard. It takes a lot of optimistic buyers to bid prices up or a lot of pessimistic sellers to bring them down, making he process very democratic. (EN: Except in rare instances where there is one buyer with a lot of cash to spend or one seller who holds a majority of the supply.)
The rational expectations theory suggests that each person acts in a manner that reflects his best estimate of the future using the information that is available to him, hence the market represents everyone's best estimate of the future using all information that is available to anyone. Between those who underestimate and those who overestimate, the market should end up just right - or just about right.
This theory applies in the aggregate - that the market averages out all valuations. It does not mean that everyone comes to the same conclusion. Even if everyone behaves rationally, they have different information available to them, and use different methods to make their predictions. Where profit is made by one prediction, it is his greater wisdom (better facts, better methods) that have caused him to have a more accurate forecast.
There's a brief mention of insider information: some investors have access to information that is known only to a small circle, generally those inside the firm who know things before the news reaches the general public. This information gives them a more accurate estimation than that of anyone who does not have access to the information, and it is often deemed an unfair advantage. This distinction is difficult to make because of the way in which news spreads - like tossing a pebble into a pond, it takes time for the waves to reach the shore. Those closer to the center will always have information before it reaches others, which gives them an advantage. At which point is it an unfair one seems arbitrary.
Valuation methods can also be unequal - each trader generally puts his faith in a model that has worked for him in the past. But is someone comes up with a more accurate model, that person has an advantage over anyone who is using a less accurate one. There seems to be no ethical or legal implications to having better tools, or knowing when one tool is better than another one - but it is similar in its effect in that the early adopters of the new method gain an advantage over others who have not yet adopted it.
Valuing Corporate Equities
Aside of bonds, corporate entities also offer equities, called "stocks" and demoninated in "shares" as each share entitles the holder to a proportionate degree of ownership in the corporation, though share-holders are generally limited to electing members of a board of directors who oversee and monitor the managers employed by the corporation, aside of the few decisions that are relegated to a vote of the general shareholders.
A share in the organization means a share in the assets of the corporation and a share of the company's net profits, which are most often reinvested in the organization than paid out in the form of dividends. The value of a share of stock is not fixed, but is determined primarily by its value in the marketplace: buyers and sellers in the stock market bid on the value of shares, and this sets their price.
There's mention of the tax benefit of retained earnings: bond investors pay taxes on interest as it is received and shareholders pay taxes on dividends when they are paid out, but the cash value of the share is not subject to taxation until the shares are sold and the seller's profit or loss is calculated. Hence the holders of stock can control their tax bill by determining when they choose to sell their shares.
There is no dependable or reliable method by which the value of stock can be determined: it is entirely up to buyers in the marketplace. If there is a belief that the company will grow, buyers will offer more for the shares, even if there is no objective evidence or even a plausible rationale for expecting that growth to occur.
In spite of this fact, there are various mathematical models for stock valuation that generally consider the net present value of the earnings of the company. Where the company is expected to earn more than the market rate of interest for risk-free investments, the value of the stock is increased proportionally. Refinements of this model might consider the return provided over an arbitrary amount of time, separate the return on the price of the stock versus income dispensed as dividends, etc.
Such models are often based on the inherent assumption that things will continue as they presently are: the company will earn the same profits and pay the same dividends in the future as it has in the past. Between the flaw in this assumption and the irrational behavior of speculators who purchase on their hope and fear, stock valuation models are notoriously inaccurate, but remain in favor of those who maintain a religious faith in mathematics.
Financial Market Efficiency
Financial markets are said to be efficient when investors' valuation of securities is accurate. That is, while different investors may have inaccurate estimation of the returns - some being too low and others too high - they average out to be an accurate prediction of the returns on investments, given the sum of all information and the results of all methods of valuation. In such a market, any investment will pay exactly the return that is expected of it - and if it fails to do so, those investors whose models are more accurate will bid the market price up or down until equilibrium is achieved.
The constant churn in financial markets is the result of disagreement among investors: those who believe that it will return more than the market expects are eager to possess it and will continue to bid up the price to buy it, while those who believe that it will return less than the market expects and are eager to be rid of it will lower their asking price to sell it. Profit in the market is therefore the result of having a more accurate prediction model.
There are also few instances in which an investor will cash out of a market entirely - so the price of investments are balanced against one another as an investor attempts to shift his holdings from overvalued to undervalued securities. And because the computerization and consolidation of world markets has made it simple for an investor to move funds from investments in any market, it is said that the market efficiency now applies to all investment in all markets into which capital can be transferred.
The computerization of markets also reduces arbitrage - the ability of an investor to take advantage of the different prices in different markets by virtue of being able to shift his funds more quickly than other investors. In general, it remains true that the first to recognize disparity and act upon it gain the greatest profit (or do the most to cut their losses) than those who recognize it later, the information is available to all investors at the same time, so the lead time that provides an advantage to early actors is a matter of milliseconds. AS a result, any unexploited profit opportunity will be eliminated as quickly as the current technology allows.
The problem with all of this theory is, again, that the value of investments is based on belief. Investors have access to the same information, but differ in the degree of faith they place in its accuracy (EN: or in the present age of information overload, they pay attention to different sources). Investors have the same valuation tools available to them, but have more or less belief in the accuracy of any given method. So two investors may be using different models to analyze data from different sources and arrive at different ideas about the value of an investment - each remains entrenched in his own beliefs, and his profit and loss are due to the accuracy of his analysis.
It is therefore possible for an investor to recognize and act upon an opportunity that others disregard as worthless and earn an unusual profit. This may cause others to question their faith in their own models, though it is more in line with human nature for people to stick to their beliefs even in the face of evidence to the contrary and dismiss as foolish those who believe otherwise.
Sidebar: Types of Efficiency
- Allocation - Believes that all investors seek to put their funds in the most profitable investments.
- Weak Form - Believes that all historical data is fully reflected in all valuations.
- Semi-Strong Form - Believes that all publicly available information is considered in all valuations
- Strong Form - Believes that all information, public and private, is considered in all valuations
Evidence of Market Efficiency
In spite of the obvious flaws in the valuation of securities, it is believed that markets are largely efficient. The line of a stock chart seems to stagger and values lurch upward and downward, but in all the trend seems to move in a similar direction because the inaccuracies in various predictions models balance one another out. The price of securities is ever-changing because the information is ever-changing: when we are able to compare out predictions of a given period's performance to the actual performance, the value of the security is adjusted proportionally and the prediction models are adjusted. Those whose prediction models are disastrously inaccurate eventually exit the market and those whose models are more accurate are imitated by others. As a result, the efficiency of modern markets is "pretty good" - but not perfect.
Critics of efficient market are quick to point out anomalous situations, such as the "January Effect" in which stock prices appeared to rise in the first month in every year as a result of investors selling off poorly performing securities at the end of the tax year and waiting to invest the funds until the beginning of the next. This phenomenon persisted for many years until prediction models were adjusted to account for it, and the predicted increase became "priced in" to the end-of-year trading prices, effectively eliminating the anomaly.
There are also anomalies that persist in spite of being recognized. The tendency of investors to overestimate the impact of change to the market causes the price of stock to drop or rise too sharply on the heels of bad or good news, then revert to a more rational valuation over the course of a few days or weeks. This is an entirely emotional reaction that has defied quantification, hence inclusion in mathematical prediction models.
Another example of emotionalism in investing is risk tolerance, which is particularly common among the small companies that trade on the fringe exchanges (on-the-curb and pink sheets) because little is known about the firm and its risk is largely a matter of gut-feel rather than calculation. The less information there is available about a firm, the more that blind speculation and unfounded beliefs influence the price buyers are willing to pay. This, too, confounds quantitative analysis.
Some of the most dramatic examples of emotionalism are in "bubbles" that are created within financial markets where many analysts place their faith in the signs that a given firm or sector will experience (or continue to experience) rapid growth and the excitement causes prices to be bid higher and higher in spite of what the fundamental analyses suggest securities should be worth. Eventually, these bubbles are popped by reality, resulting in a crash in which prices plummet, and it may take years or decades for the market to regain its efficiency.
The author suggests that the emerging science of "behavioral finance" will eventually sort out the emotional factors by considering not just the value of the companies, but the behavior of investors from a psychological/sociological perspective, as it is the emotional behavior of individuals and crowds that has the most direct and immediate influence on the price of securities and can skew the value by a significant amount and for a significant amount of time before cooler heads prevail.