Capital Ideas by Bernstein Peter L

Author:Bernstein, Peter L.
Language: eng
Format: epub
Publisher: Wiley
Published: 2012-08-23T16:00:00+00:00

Chapter 10

Risky Business

Knack, feel, whim, and intuition are . . . useless relics.

Markowitz, Tobin, and Sharpe all describe rational investors as masters of their fate. The theories of portfolio selection show investors choosing this asset over that, carefully balancing risk against expected return, and arranging their choices into optimal combinations called efficient portfolios.

Samuelson and Fama describe a different world. In their theories of market behavior, investors are no longer masters of their fate; they are at the mercy of unrelieved bedlam and the Demon of Chance. Even if investors happen to look smart occasionally, Jensen, Cowles, and Osborne are quick to remind us that they are nothing but egotistical orangutans. After all, didn’t Bachelier, decades ago, prove that the expected return in a speculative market is zero?

In the Modigliani and Miller model, conscientious investors make judgments about the riskiness of each corporation and then meticulously apply John Burr Williams’s rules to their expectations of the corporation’s future earnings stream. Most players are not so painstaking, but the essential principle is valid. Noise traders who take their tips from stories told at cocktail parties, chase only what is hot, and dump their stocks in a panic lose out in the long run, no matter how smart they may seem in the short run. They end up selling too cheaply to better-informed, more patient investors, or else they pay too dearly for stocks that more systematic investors are kind enough to sell them. Modigliani and Miller understood this pattern of behavior. They conclude their 1961 article on the relevance of dividends with the comment, “Investors, no matter how naive they may be when they enter the market, do sometimes learn from experience.” They add, “[P]erhaps . . . even from reading articles such as this.”1

MM theory demonstrates that it is the market—that is, all the investors buying and selling at any given moment—that fixes the value of the corporation. Granted, the board of directors, the chief executive officer, and the chief financial officer deploy the corporation’s assets for future growth and decide how to finance the corporation. But their decisions do no more than influence investor perceptions. An entire profession of investor relations consultants has sprung up to sway those perceptions, and annual reports often carry as much hype as information. Still, research reveals that investors have a sharp nose for smelling out the truth for themselves.

Thus, Modigliani and Miller put investors back in the catbird seat, with corporate managers at their mercy. Through arbitrage, profit-seeking investors can eliminate discrepancies in the perceived risk/return trade-offs of one security relative to another to the point where no one has any incentive to buy or sell. Trades take place only when investors disagree about the future of a company or when new information surfaces. Modigliani and Miller’s market is a market in equilibrium.

And yet equilibrium is only a rough approximation of reality, because information pours into the marketplace constantly, in every shape and form. Most investors are restless, and even those who are more relaxed are beset by brokers hurrying to tell them what stocks are hot.

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