Capital 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.