Wine investors are likely to be wealthy individuals who personally select the wines they want, decide what price they’re willing to pay, and store their acquisitions in a private wine cellar. In the language of neoclassical finance theory, individual investors strive to make intertemporal utility-maximizing choices using a discount rate that balances immediate and deferred consumption. In the standard model, prices are set by final consumers or investors. This theory eminently applies to the market for collectible wines.
Cornell argues, however, that the standard model does not fit the modern securities investment environment. On the basis of high-level research, he and his co-author, Jason Hsu, state that final investors do not set the prices of financial assets. Instead, acknowledging (whether openly or tacitly) that they have neither the information nor the training to identify mispriced stocks, asset owners delegate decision-making to investment professionals, either by buying managed funds or by engaging financial advisors. Investment professionals are the marginal price-setters.
Moreover, investment professionals don’t use a utility-maximizing model for asset pricing; they overwhelmingly use simpler discounted cash flow techniques to estimate fundamental values. There is evidence that, in an attempt to set themselves apart, advisors expend considerably greater effort developing cash flow projections than selecting the proper discount rate. Nonetheless, the cross-section of expected returns is determined by the marginal investors’ discount rates; and those discount rates, in turn, are determined by the marginal investors’ models. There is, consequently, a feedback loop, via discount rates, between asset pricing theory and the prices of financial assets. Cornell says that the implications of this feedback loop remain to be explored.
Delegating discretionary authority does not lead to a clear-cut principal-agent relationship; investment committees, consultants, regulators, and, in some cases, layers of distributors have roles to play. Investment committees, which are prone to small-group politicking, retain consultants to share the liability for their decisions, and the consultants have their own business objectives. Regulators, always playing catch-up, attempt to protect the investing public and their own bureaucracy by enforcing an ever-expanding set of detailed requirements. Distributors may be concerned as much about a product’s fee structure as its suitability for individual clients. In short, the modern financial services industry is a complex ecosystem. The volume (in both senses: quantity and loudness) of hot financial information is a further complication; media personalities don’t understand investing, and they are driven by the very-short-term news cycle to focus on what’s trending.
If the asset owners are dissatisfied with the professionals’ performance, they terminate the relationship, typically after three years. In consequence, investment professionals’ recommendations and actions may not be fully aligned with their clients’ true long-term interests. In order to maintain a steady (or, better yet, steadily growing) stream of advisory fees, investment professionals are financially incentivized to focus on short-term performance relative to a benchmark. This compensation structure does not make it easier to manage clients’ portfolios in view of rational long-term objectives.
Grounded in psychology and experimental economics, behavioral finance purports to shed light on investors’ actual decision-making processes, which are susceptible to cognitive error and influenced by non-financial needs and desires. Thus, like neoclassical finance, behavioral finance crucially assumes that investment decisions are made by the ultimate consumers—individual investors. This presupposition does not reflect the reality of asset pricing in the complex investment ecosystem.