October 16, 2013

Irrelevant Sideshows

They keep you from getting lost in irrelevant sideshows.

That’s how University of Chicago economics professor John Cochrane described the benefits of asset-price models in a WSJ piece yesterday about Nobel winners Eugene Fama, Lars Peter Hansen and Robert Shiller.

Two alert readers sent me notes when the Royal Swedish Academy of Sciences proclaimed the recipients. Our models here also depend on measuring prices and behaviors in combination, concepts these fellows pioneered.

Like the cowboy adage on how to double your money (fold it over and put it back in your pocket – something Washington DC could stand to grasp), both John Cochrane’s quip and the work these gentlemen have done simplifies the complex.

We can thank them for much of what we know today about financial-market behavior, from the rational to the psychological. We understand that markets are generally efficient but occasionally random, that risk affects investment behavior and outcomes and how we perceive value.

Behavioral finance owes them too for its modern prominence in everything from high-frequency trading models to the Federal Reserve’s beige book of key economic indicators.

We today broadly recognize Robert Shiller’s Case-Shiller Home-Price Index, which measures average prices against the rate of change in them. Shiller’s work in the 1970s served as seedbed for behavioral finance.

Investor-relations at root is fostering fair value. Yet here we arrive at a remarkable confluence of rationality and psychology. IR embraces the rational-investor thesis but generally rejects behavioral finance – the basis for arbitrage – when quantifying market-behavior. One is relevant, the other a distraction not worth measuring. Yet Nobel Prizes have been awarded for work demonstrating behavioral effects in asset-price models.

Even more striking, there’s not a skeptic of behavioral analytics who doesn’t say to me, “Over the long term, prices revert to the mean.” That’s tantamount to proposing that no public company needs an IRO.

Thanks to our Nobel winners, institutional money has embraced behavioral finance in asset-valuation. Alpha – returns without increased risk – dominates. Risk-analytics is a giant business, with Blackrock Solutions selling its quantitative tools to $14 trillion of institutional assets, and firms from MSCI to McGraw-Hill worth billions in part by providing proverbial safety suits and goggles to traders and money managers.

Risk-analytics are principally proof of the prevalence not of the rational-investor theorem but its opposite. Behavioral finance. If the market were rational, who’d need those? Yet roughly 90% of IR departments don’t model market behavior – the opposite of the investors they seek.

While institutions are pursuing alpha, which isn’t a product of rational behavior since Eugene Fama’s efficient-market hypothesis shows how markets equalize available information, IR budgets are swallowed by rational-investor pursuits (surveillance, perception studies, travel and outreach, IR communications).

This hit me: The lead thread at the NIRI discussion forum this week was hardcopy handouts at investor meetings, while at TABB Forum where traders and investors coalesce, the headline yesterday was “Can Fragmentation Be Stopped?”

And 90% of trading flows through 30 firms, while perhaps 80% of your shares are held by 30 investors.

An irrelevant sideshow may be blocking the view of reality from the IR chair. We have clients who spend hundreds of thousands of dollars on tools, and ones putting down a few thousand annually for market-structure analytics alone, and there is no advantage in outcomes, at all, for the big spenders.

I’ve concluded that three things matter most: First, tell your story to a diverse palette of investment horizons. Second, know what’s going on, measuring both rational and behavioral realities. Third, use these data to maintain great relationships with those diverse investment horizons.

Then adopt a standard measure for fair value and track how your market price compares (we offer standards: Rational Price, Gamma). You will have skirted the sideshows and adopted the sort of thinking that leads to prizes. Maybe you’ll be the first Nobel winner in IR.

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