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Financial Strategy, Second Edition by Devendra Kodwani, Martin Upton, Janette Rutterford

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CASE STUDY 2

Do Fundamentals – or Emotions – Drive the Stock Market?

Marc Goedhart, Timothy Koller and David Wessels

There's never been a better time to be a behaviorist. During four decades, the academic theory that financial markets accurately reflect a stock's underlying value was all but unassailable. But lately, the view that investors can fundamentally change a market's course through irrational decisions has been moving into the mainstream.

With the exuberance of the high-tech stock bubble and the crash of the late 1990s still fresh in investors' memories, adherents of the behaviorist school are finding it easier than ever to spread the belief that markets can be something less than efficient in immediately distilling new information and that investors, driven by emotion, can indeed lead markets awry. Some behaviorists would even assert that stock markets lead lives of their own, detached from economic growth and business profitability. A number of finance scholars and practitioners have argued that stock markets are not efficient – that is, that they don't necessarily reflect economic fundamentals.1 According to this point of view, significant and lasting deviations from the intrinsic value of a company's share price occur in market valuations.

The argument is more than academic. In the 1980s the rise of stock market index funds, which now hold some $1 trillion in assets, was caused in large part by the conviction among investors that efficient-market theories were valuable. ...

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