Why Can't Johnny Invest? A Short Discourse on Risk and Rationality

 

One of the key assumptions of Corporate Finance is that market participants in general, and investors, in particular, are "rational." A quick scan of the financial pages (and, particularly, the market value of just about any firm with ".com" in its name) is enough to make some people question this assumption. Just what does rationality mean, and why is it important in Corporate Finance? Classical microeconomic theory begins with man as homo economicus - the rational economic man, who makes economic decisions on the basis of two attributes: risk and return. Specifically, homo economicus prefers higher returns to lower (i.e., more money to less), and prefers less risk to more. (Virtually every Finance professor worth his or her salt will recognize this as one of the economic foundations of the "two-parameter model" immortalized by Harry Markowitz, William Sharpe, et al.)

The importance of rationality to Corporate Finance is, perhaps, obvious. If the two-parameter model accurately describes the way investors behave when faced with uncertainty, then risk and return are the primary (some would say only) relevant factors to consider when evaluating investment and financing decisions. And, it follows that rational investors will value financial assets, well, rationally; i.e., on the basis projected returns and the riskiness of those returns.

The motivations for this brief discourse are threefold. First, as noted above, the values of internet stocks are (seemingly) stratospheric. In the last few weeks, the IPOs of eBay, EarthWeb, and Broadcast.com have all skyrocketed from their offering prices. And the market capitalizations of such "old" internet firms as Amazon.com remain huge (albeit highly variable).

Second, a recent opinion piece in The Wall Street Journal seriously questions the "rational man" foundations of economic thought. As Alan Murray points out:

"From David Ricardo at the beginning of the 19th century to Myron Scholes and Robert Merton at the end of the 20th, economists have built elaborate mathematical models on the breathtakingly faulty assumption that human beings behave rationally." (emphasis added).

He goes on to suggest that ". . . the ability of irrational hope and fear to overwhelm reason is what makes life interesting-and economics unreliable. What rational theory of human behavior could explain why, a few months ago, investors were snatching up stocks at prices that far exceeded any reasonable expectation of future profirts? Or fighting to get in on initial public offerings of technology companies that had never earned a profit?"

The essay continues in a similar vein, and ends on the following (rather troubling) note: "Will the current mood and trends end in recession? That's still unclear. But no amount of number-crunching can provide the answer."

Finally, an article in the November 9, 1998 issue of Fortune shifts the focus from the macro-effects of irrational behavior to the micro-effects. Titled "Why Johnny Can't Invest" (yes, I did, er, borrow the title for this discussion), Brian O'Reilly contends that "people just aren't wired to be rational about money." The article describes three amusing (and documented) behavioral phenomena you may wish to share with your students.

Phenomenon 1: The Two-Pocket Gambler

Suppose you take $1,000 to a casino, and win an additional $1,000. How will you treat your two $1,000 holdings? Chances are, you'll treat the initial $1,000 as one would expect - i.e., spending it carefully. The $1,000 winnings, on the other hand, will be thrown around like you're Bill Gates. In other words, you have mentally categorized the funds (identical assets) into "hard-earned money" and "free money." Put another way, your required return on the former is different than that on the latter, although they are identical assets.

Phenomenon 2: Unjustified Overconfidence

Ask your students to raise their hands if they believe they are good drivers. (Nearly all of them will raise their hands.) Then ask them to raise their hands if they feel they are better-than-average drivers. Most will raise their hands again. (When people are surveyed, 80% state that they are better-than-average.) But how can the majority be better-than-average? Obviously they can't, but surveys, as well as a series of papers by Terrence Odean indicate that most investors have a great deal of confidence in their investment ability. (Several of his papers can be found at http://www.gsm.ucdavis.edu/~odean/. I highly recommend them!)

In sum, we have a situation in which the theory and reality diverge. Perhaps the real question is: Do they diverge significantly enough to call our Finance framework into question? And if so, with what should it be replaced? Those are questions for another day.

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