Flaws expose free markets to corrective measures

LONDON Wed May 18, 2011 10:08am BST

An investor reacts in front of an electronic board showing stock information at a brokerage house in Huaibei, Anhui province May 12, 2011. REUTERS/China Daily

An investor reacts in front of an electronic board showing stock information at a brokerage house in Huaibei, Anhui province May 12, 2011.

Credit: Reuters/China Daily

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LONDON (Reuters) - Increasing myopia among investors and distorted financial pricing may be exacting a high economic and social toll.

What's been clear to most observers since the credit crisis brought the world's biggest financial firms close to collapse and triggered the deepest global recession in recent history is that free markets don't always deliver optimal outcomes and the self interest of shareholders can't always be relied upon.

In a world where financial market pricing now touches so many lives directly -- from the cost of food and energy, housing finance, retirement savings or even the stability of sovereign finances and national budgets -- growing realisation of market flaws may push the political debate towards taming market power.

What's more, the questions come at a time when the centre of gravity in international economic policymaking has shifted more toward emerging powers such as China and Brazil who are less in thrall to the basic tenets of market fundamentalism.

Examining the extent of equity investors' short term focus and the damage done to long-term investment and growth, Bank of England economist Andrew Haldane reckons his evidence points to persistent risk of market failure.

This month's paper by Haldane, the BoE's executive director for financial stability, and co-author Richard Davies showed how excessive discounting of future company cashflows had put far greater value on firms' short-term earnings generation.

Haldane found that in both the United States and Britain that investors were now discounting 5-year cashflows at rates more appropriate at 8 years hence, 10-year cashflows as if they were more than 16 years or more away and cashflows of more than 30 years as if they barely had any value at all.

In essence, the further away or more stretched-out the return on investment, the less value is placed on the firm today -- leading in some cases to viable long-term projects such as infrastructure or high-tech being shelved.

"These projects are often felt to yield the highest long-term (private and social) returns and hence offer the biggest boost to future growth. That makes short-termism a public policy issue," said Haldane.

"Investment choice, like other life choices, is being re-tuned to a shorter wave-length. Public policy intervention might be needed to correct this capital market myopia."

NOT SO EFFICIENT

Among measures the paper put forward as possible corrective surgery for this short-sightedness were sliding scales of shareholder voting rights that would depend on the duration of stock holding or ultimately the use of government taxes or subsidies to encourage ivestors to hold equity for longer.

The study builds on prior work by Haldane and others on the lack of patience in finance, where superior annual returns from short term "momentum" investing have led to greater churn and volatility and cut average equity holding periods.

For example, the mean duration of equity holdings on the New York Stock Exchange has fallen from as much as seven years in 1940 to under two years in 1987 and just seven months in 2007.

The net result of this herding, Haldane argues, is that equity prices persist at levels far from fundamental valuations for longer, while higher medium-term volatility acts like a tax on committing long-term capital.

Studies like this were dismissed for many years prior to the credit crisis in favour of the "efficient markets hypothesis" that said more and unfettered trading activity created a superior good of liquidity and price transparency.

But after light-touch or non-existent regulation of finance led to near disaster, such "efficiency" is now under scrutiny.

Another paper this month by Tarek Hassan of the University of Chicago and New York University's Thomas Mertens argues that market prices, far from efficiently incorporating all available information, are distorted by small errors of judgement.

For example, if investors are slightly too optimistic or pessimistic about future productivity in a company they will buy or sell the stock. Others then seeing the price rise, and assuming efficient markets, view that as a signal to buy too.

In other words, the price may appear efficient but it's not aggregating all the information correctly. It then follows, the economists argue, that the increased price volatility depresses capital investment, economic growth, jobs and consumption.

"The social return to diligent investor behaviour is thus orders of magnitude larger than the private return," said Hassans and Mertens, whose model shows tiny household investment errors spur an 18 percent rise in stock return volatility and a social cost of 2.3 percent of lifetime consumption.

Yet, more regulation or not, the financial industry is already trying to cope with these market flaws and more firms are using behavioural analysis and investor profiling rather than assuming perfectly rational choices are always made.

"Traditional finance models are based on ideal investors who are rational, non-impulsive and endlessly patient," University of Zurich professor Thorsten Hens said in a series of papers released by Credit Suisse. "Evidence of irrational markets has now become so overwhelming that the general public is eager to learn what the new research has to teach."

(Editing by Ruth Pitchford)

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