Lunch with Warren Buffet is auctioned on eBay every year. In 2008 a Chinese fund manager paid a record $2.1 million to have a chance to talk to the world’s most famous financial guru about his preferable investment strategies. Isn’t it too pricy?
As the classical approach to financial markets suggests, differences in prices of stocks exist due to different levels of risks associated with them, and rational investors immediately eliminate all the arbitrage possibilities caused by less rational investors. Then why Warren Buffet became so rich? Why sometimes we can observe investment strategies that are highly profitable but not very risky at the same time?
The common idea is that some assets are probably mispriced. Their prices are not equal to their fundamental value, i.e. the discounted sum of expected future cash flows. This deviation can arise when investors are not fully rational and do not update their beliefs correctly or/and do not make their choices according to strong theoretical notions. Actually, mispricing represents an attractive investment opportunity that is supposed to be grabbed by some lucky rational investors like Warren Buffet. The problem is that sometimes these investment strategies are too risky and too pricy, which implies that arbitrage doesn’t work anymore.
Behavioral finance proposes an alternative approach to financial markets that is built on two important notions. First, there are certain limits to using arbitrage strategies. Many arbitrage opportunities remain unattractive and unsolved which results in unpredictable asset price movements. Second, psychology matters. The way investors form their beliefs by under- or overreacting to news, showing overconfidence while dealing with their private information makes them irrational and purely emotional human beings.
Limits to arbitrage and mispricing
In order to illustrate behavioral finance plausibility we consider the following example. Assume that fundamental value of eBay share is $30. But some irrational traders become really pessimistic about the viability of eBay business that they push market price of eBay stocks down to $20. According to standard financial theory predictions rational traders are supposed to buy in long position eBay stocks at the current market price and at the same time go short in some perfect substitute stocks say Amazon which has similar future cash flows. This kind of speculative demand is supposed to increase the price of eBay stocks back to its fundamental value.
In reality eBay stocks move daily and probably never reach their fundamental value. There are certain kinds of risks and costs that enable this kind of mispricing to survive. They are known as fundamental risk, noise trader risk and implementation costs.
Fundamental risk arises when we cannot consider Amazon as a perfect substitute stock to mitigate the risks concerning eBay’s fundamental value. If investors proceed to receive bad news about eBay perspectives and the price of its stocks continues falling then arbitrage strategy of short position in Amazon is not suitable. Actually, perfect substitute securities don’t exist. Buying in short Amazon we can be protected from the bad news about e-commerce industry in general but fundamental risk in eBay can not be eliminated.
Even if we are able to find a perfect substitute for a certain asset we can not predict the price divergence. Traders may become more and more pessimistic about eBay affairs that the price of the stock will continue to decrease. This kind of risk is called noise trader risk. Mispricing cannot always be avoided in short run.
Also, mispricing can be subject to implementation costs that means all kinds of transaction costs associated with realization of arbitrage strategy. There are different types of commissions, bid-ask spreads which make short position in a certain stock less attractive compared to long position.
There is certain evidence suggested about limits to arbitrage and plausibility of behavioral finance. Actually, any case of mispricing calculated as a difference between the market and the fundamental prices can be treated as a proper evidence. But possible critics arises about the fact that while testing mispricing hypothesis we test the model of proper discounting of flows as well. That is why more accurate evidence is required.
Royal Dutch and Shell Transport
By 1907 Royal Dutch and Shell Transport were totally independent companies when they decided to merge their businesses at the proportion of 60 to 40 but to remain separate enterprises. Shares of Royal Dutch that were traded in the USA and in the Netherlands became subject to 60% of total cash flows of both companies. Shares of Shell Transport traded in the UK had claim to the rest 40%.
In the absence of mispricing shares of Royal Dutch are always supposed to be traded at the level 1.5 times higher than the shares of Shell Transport (as the ratio 60 to 40). But in reality it was not the case.
On Figure 1 we observe deviations of the ratio Royal Dutch market prices to Shell Transport market prices from the effective market benchmark of 1.5. As we can deviations always take place and sometimes they are rather significant (ranging from -42% in 1981 to +10% in 1987).
S&P 500 and Yahoo
Sometimes new companies are added to S&P 500 listing while other companies are taken off. There is great evidence provided on these index movements, stocks can experience dramatic rises in market price when they are newly added to a certain index. For example, when Yahoo was added to S&P 500 index its shares rocketed by 24% during a single day.
This is again considered as an evidence of possible mispricing. As Standard and Poor’s reminds their selection of certain companies to be included to or withdrawn from the index doesn’t convey any information about changes in risks associated with these certain companies, it’s no more than an attempt to provide US economy representativeness. That is why these great changes in stock prices cannot be provoked by any changes in company’s fundamental value.
3Com and Palm
3Com is a supplier of local area network (LAN) and wide area network (WAN) systems. Palm is a global provider of handheld computing devices, and it’s a part of 3Com business. On 2 March 2000, 3Com sold 5% of Palm enterprise on IPO and kept ownership of the rest 95%. As the result, after IPO a typical shareholder of 3Com indirectly owned 1.5 shares of Palm.
Palm shares were issued at $38. On the first day of trading Palm went directly to $150 and later rose to $165 before ending the day at $95. Based on a relative number of shares of Palm and 3Com for a typical shareholder, we expect a share of 3Com to be $142 on the end of the day. But in fact the observed price was only $81 (which was provided by 21% drop during the day). This leads to the fact that market valuation of 3Com’s substantial businesses outside Palm is negative and about -$60 per share.
This example provides kind of a puzzle for traditional finance and suggests that market prices are driven by other than rational arbitragers factors.
Table 1 provides possible risks and costs associated with the examples of mispricing mentioned above. In case of Royal Dutch/ Shell affair, we can observe only noise trader risk that makes one stock more undervalued than another one. There is no fundamental risk as both stocks are treated as twins, therefore perfect substitutes to each other. Implementation costs do not arise as well, both stocks can be easily shorted.
In case of inclusion of Yahoo in S&P 500 index both fundamental and noise trader risks are observed. Arbitrage becomes limited as it is quite difficult to find a perfect substitute in order to be able to short the included stock. Due to noise trader risk, deviation of Yahoo prices from its fundamental value are being observed even long time after inclusion.
But considerable implementation costs were associated with Palm/ 3Com case, as demand for Palm stocks to be shorted became high, there were no enough stocks available at a reasonable price. Neither fundamental nor noise trader risks were observed, deviation of Palm prices from its fundamental value existed only during several weeks.
Apart from the limits to arbitrage, there is also some evidence on the influence of psychological factors on stock prices. Investors as human-beings tend to react emotionally to financial news, be overconfident about their private information on markets, hate losses more than gains, and so on. But all these highly recognized psychological features are extremely difficult to be observed and measured. This is a subject of experimental economics which sets field experiments about behavior of investors in conditions which resemble more or less that of financial markets (risk perception testing, etc.).
Actually, evidence on link between psychology and financial markets is rather difficult to be supported empirically. Psychological features of private investors are almost impossible to measure in market conditions. Though, some papers try to provide empirical tests of weather effect on investors’ perceptions and therefore their market behavior. Geomagnetic storms can be used as one of these examples.
According to some psychological researchers, geomagnetic storms may have a profound effect on people’s moods (?!), and in return this influences their behavior and daily judgments and decisions concerning risk. People might be more likely to sell stocks on stormy days because they incorrectly attribute their bad mood to worsening economic prospectives rather than to bad environmental conditions. This results into a relatively higher demand on less risky assets and decline of more risky assets’ prices (Figure 2).
After controlling for market seasonals and other environmental and behavioral factors, strong empirical support is provided for an effect of geomagnetic storms on stock prices movements. High levels of geomagnetic activity have rather strong negative effect on following week’s stock returns for all trading platforms considered. Nevertheless, we suggest to interpret cautiuiusly these rather puzzling and defiant results.
Irrationality matters. Every time trying to solve the puzzles about dynamics of financial markets we need to keep in mind that all possible rational explanations are just convenient models for a constructive discussion and, therefore, they have limited power.
Investors’ perception of risk and information is more complicated than we used to think. Financial markets show lots of examples of mispricing which means that possibilities to use arbitrage in order to diversify risk and at the same time to receive profits are limited. It is difficult to find a perfect substitute for a certain stock, that is why fundamental risk is not always mitigated. Also noise trader risk exists when in a long run investors tend to overreact about the prospectives of a certain stock causing great price divergence from stock’s fundamental value. Implementation costs are associated with limits to buy and sell stocks while constructing appropriate arbitrage strategy.
Apart of limits to arbitrage, psychology matters. There is only one Warren Buffet behaving in his rather unpredictable and unexplainable way that theorists have nothing to do while trying to guess his secret and become no less successful and famous. All we try to say is not about the fact that financial markets are nothing else than a mess. As behavioral finance is becoming more and more popular, there is a need to be more open-minded and discuss financial markets from behavioral and human-oriented perspective.
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