Do Fundamentals or Emotions Drive the Stock Market?

Emotions can drive market behavior in a few short-lived situations. But fundamentals still rule.

There’s never been a better time to be a behaviorist. During four decades, the academic theory that financial markets accurately reflect a stock’s underlying value was all but unassailable. But lately, the view that investors can fundamentally change a market’s course through irrational decisions has been moving into the mainstream.

With the exuberance of the high-tech stock bubble and the crash of the late 1990s still fresh in investors’ memories, adherents of the behaviorist school are finding it easier than ever to spread the belief that markets can be something less than efficient in immediately distilling new information and that investors, driven by emotion, can indeed lead markets awry. Some behaviorists would even assert that stock markets lead lives of their own, detached from economic growth and business profitability. A number of finance scholars and practitioners have argued that stock markets are not efficient — that is, that they don’t necessarily reflect economic fundamentals. (For an overview, see Jay R. Ritter, “Behavioral Finance,” Pacific-Basin Finance Journal, 2003, Volume 11, Number 4, pp. 429–37; and Nicholas Barberis and Richard H. Thaler, “A Survey of Behavioral Finance,” in Handbook of the Economics of Finance: Financial Markets and Asset Pricing, G. M. Constantinides et al. (eds.), New York: Elsevier North-Holland, 2003, pp. 1054–123.) According to this point of view, significant and lasting deviations from the intrinsic value of a company’s share price occur in market valuations.

The argument is more than academic. In the 1980s the rise of stock market index funds, which now hold some $1 trillion in assets, was caused in large part by the conviction among investors that efficient-market theories were valuable. And current debates in the United States and elsewhere about privatizing Social Security and other retirement systems may hinge on assumptions about how investors are likely to handle their retirement options.

We agree that behavioral finance offers some valuable insights — chief among them the idea that markets are not always right, since rational investors can’t always correct for mispricing by irrational ones. But for managers, the critical question is how often these deviations arise and whether they are so frequent and significant that they should affect the process of financial decision making. In fact, significant deviations from intrinsic value are rare, and markets usually revert rapidly to share prices commensurate with economic fundamentals. Therefore, managers should continue to use the tried-and-true analysis of a company’s discounted cash flow to make their valuation decisions.

When Markets Deviate

Behavioral-finance theory holds that markets might fail to reflect economic fundamentals under three conditions. When all three apply, the theory predicts that pricing biases in financial markets can be both significant and persistent.

Irrational behavior. Investors behave irrationally when they don’t correctly process all the available information while forming their expectations of a company’s future performance. Some investors, for example, attach too much importance to recent events and results, an error that leads them to overprice companies with strong recent performance. Others are excessively conservative and underprice stocks of companies that have released positive news.


Your email address will not be published. Required fields are marked *