Money, Money, Money, Ain't It Funny . . . by Sheryl Sutherland

Author:Sheryl Sutherland [Sheryl Sutherland]
Language: eng
Format: epub
ISBN: 9781775531524
Publisher: Random House New Zealand
Published: 2012-10-14T16:00:00+00:00

FEELINGS AND FINANCE

Traditional financial theory expects each investor to make rational decisions using tools such as fundamental analysis and modern portfolio theory. These tools require assumptions about the future. What growth rate will the firm or fund achieve over the next three years? What are its expected return or expected correlation with other assets? As investors we are meant to resolve these uncertainties in an unbiased, unemotional way. If you feel unable to do that or haven’t in the past, don’t despair – even sophisticated, experienced investors can’t agree about which methods produce the most accurate assumptions. And, as we have seen, the experts can display the same biases as mere mortals like us. Even those investors who use quantitative methods, such as fundamental analysis, must include educated guess work about some assumptions – some analytical techniques are more sophisticated than others, but they all involve assumptions about the future. Consider, for example, the constant discountrate model taught to finance students around the world, PV = D1 / (K-g). Investors must estimate the constant growth rate ‘g’. Given the influence of mood on risky and uncertain decisions the expected value of the growth rate may become biased. In turn, this biases the value computed in the model.

An investor who is in a good mood might optimistically overestimate the growth rate to be 7 per cent. This would cause the investor to think the share is worth 2 per cent more than the belief of an unbiased investor.

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