Section 1
Trends in Finance Theory
Section Overview
Janette Rutterford
The typical approach to teaching finance today is to cover the classic theories underpinning the subject area – portfolio theory, the Capital Asset Pricing Model, optimal capital structure and dividend policy, and the valuation of derivatives. The assumption is that managers behave – and have always behaved – in a way which these models predict. Finance theory now has a relatively long history and it is instructive to look at how management and investor behaviour has changed as finance theories have evolved.
The Trends in Finance Theory section to the book examines how finance theory has evolved over the last 100 years or more. The papers and cases in this section chart a trend away from a subjective and intuitive approach to finance problems a hundred years ago to a more rigorous modern approach to finance, with theoretical models backed by empirical analysis. This section also looks at a more recent development, behavioural theory, which takes a step back from theoretical models such as portfolio theory and the Capital Asset Pricing Model and tries to explain stock market phenomena which are anomalies in the context of efficient markets and rational investors.
The first article, “The World was their Oyster”, goes back to pre-World War I days to look at how British investors constructed investment portfolios. This was fifty years or more before Markowitz formalised portfolio theory and the concept of “optimal” portfolios in a risk/return sense, and also well before Sharpe et al. developed the Capital Asset Pricing Model which led to the development of performance benchmarks for investment portfolios. What emerges from this paper is that investors pre-World War I had, without access to Markowitz's model, developed what they called a “scientific” approach to portfolio construction. This was, in today's terminology, a top-down “naïve” diversification strategy. They divided the world into ten geographic regions and invested equal amounts in one stock from each region. They chose stocks of similar yield for their portfolios, varying the yield according to how much risk they wanted to take on. In those days, risk was not measured by the standard deviation of returns, it was simply measured by yield. The higher the yield, the higher must be the risk. By using this “scientific” approach, investors adopted a passive strategy, investing in the “market” portfolio. But in their case, the market was the world, not just the UK or US stock markets.
By the end of the twentieth century, investors were well aware of both the portfolio theory model elaborated by Markowitz and the Capital Asset Pricing Model (CAPM) developed by Sharpe and others. The CAPM, as with the “scientific” investment approach, shows that, given certain underlying assumptions, an optimal passive investment strategy is to buy and hold the market. Developed by American academics, the CAPM can only with difficulty be applied to an international portfolio. But the CAPM does lead to a linear equation explicitly linking the expected return to the risk of a portfolio or of an individual stock in a particular market. This means that managers and investors can estimate the expected return, and hence the cost, of equity at a market, portfolio or individual company level. This in turn can be used in the Weighted Average Cost of Capital (WACC) formula, derived by Modigliani and Miller, to discount, and hence value, forecast cash flows for equity valuation or project appraisal purposes.
Although the CAPM is simple and elegant, estimating the cost of equity still requires empirical analysis to provide estimates of the coefficients in the risk/return equation; in particular, the equity Beta1 and what is called the equity risk premium, that is, the difference between the expected return on a stock market, and the risk-free rate of return in that market, usually measured by the return on a long-term government bond. The higher the equity risk premium, the higher will be the corporate cost of capital, and the lower the net present value of project cash flows discounted using the WACC. The lower the equity risk premium, the higher share prices will be. One of the arguments put forward for the stock market boom of the 1990s was that the equity risk premium required by investors had fallen; in other words, that investors viewed equities as less risky than in the past, and were as a result prepared to accept a relatively lower rate of return. So the size of the equity risk premium is one of the important inputs to corporate financial strategy. But it is exceedingly difficult to know, even with a model to put it in, what the correct value for the equity risk premium should be.
Case Study 1, “Global Evidence on the Risk Premium”, by Elroy Dimson, Paul Marsh and Mike Staunton, attempts to measure the long run equity risk premium across different countries. The paper highlights how the equity risk premium varies across countries as well as over time, an important issue for both domestic and international companies. It gives us an indication of how, even with a simple and elegant model such as the CAPM, using it in practice is fraught with estimation difficulties. We are not so far away, after all, from the pre-World War I “scientific” investors.
The second article in this section relates to behavioural finance – or “Behavioral Finance” as it is spelt by its US author, Jay Ritter. This new stream of finance literature tries to explain – using investor behaviour – stock market phenomena which cannot be explained by classical finance theory. One of the most puzzling phenomena is stock market bubbles. Why is it that stock markets rise to very high levels, as happened at the end of the 1990s, and then fall back dramatically, as happened in 2000–2002. What can explain the dot.com or “new economy” boom, where companies with less than five years' track record, and still not profitable, could be worth more in stock market terms than long-established blue chip companies? What is it about investor behaviour which can lead to such price trends? Or, more prosaically, how can a company such as Royal Dutch Shell, quoted on the Amsterdam and London Stock Exchanges, be quoted at different prices for the same underlying assets? Are investors irrational? And what about managers? Why is it that mergers and acquisitions are cyclical? When stock market prices are high, merger and acquisition activity is also high. When stock market prices are low, so is M&A activity. Why are companies bought when their prices are high? Are managers, too, irrational? The article sums up the current thinking on behavioural finance and shows that, at yet, researchers have only scratched the surface of this very promising area of research.
Case Study 2 is a McKinsey article, “Do Fundamentals – or Emotions – Drive the Stock Market?”, by Marc Goedhart, Timothy Koller and David Wessels. It looks at some of the classic apparently irrational stock market phenomena, such as the Royal Dutch Shell example, and discusses the impact for managers of firms quoted on the stock market.
NOTE
1. The Beta is a measure of the relative cyclicality of a share compared to the stock market as a whole. Beta is 1 when its cyclicality is the same as that of the market; less than 1 when less cyclical than the market; greater than 1 when more cyclical; and 0 when risk-free.