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Opinion

Inside Investment: Agents of change

Markets are more susceptible to the herd mentality and the creation of bubbles because of agents’ behaviour. Following the money can solve a large part of the asset price puzzle.

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Many practitioners in financial markets and nearly all academics live in a constant state of denial. They believe markets are efficient. This creed is the cornerstone of Modern Portfolio Theory, CAPM and the Black-Scholes options pricing model. Yet, the idea that participants in markets act rationally with regard to returns and risk and that therefore assets are priced correctly and prices are constantly adjusting to new information is plainly, empirically, wrong. The 1987 crash, the dotcom boom and bust, the manifest mispricing of credit (in part a by-product of the biggest bubble in house prices ever seen) are just four examples from recent times of inefficient markets.

The role of financial institutions in setting asset prices has largely been ignored in the academic literature. But these institutional investors now dominate share ownership across the world. The big are also getting bigger. Between 1980 and 2000, the biggest 100 US mutual fund managers more than doubled their market share from 19% to 40%.

This is important because agents have very different motivations to principals. The dotcom bubble is a good example of what this means in practice. Many fund management firms abandoned long cherished value-oriented investment processes and joined the party, loading up on hot tech stocks.

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