What Really Drives the Market?

The principle that financial markets accurately reflect the underlying value of traded stocks has been widely accepted in the investment world since the 1960s. It is predicated on the assumption that investors make buy or sell decisions based on a rational view of a company's future cash flow, after considering all the relevant information. The role of the markets is to allocate capital to companies efficiently. Recently, however, this rational view has been under attack from adherents of behavioral finance, who argue that stock markets do not reflect economic fundamentals as well as people think they do. The authors maintain that there are instances when stock market valuations can and do make significant and lasting deviations from a company's intrinsic value. However, according to the authors' analysis, the significant discrepancies between market value and intrinsic value are both rare and short-lived. The article cites several examples, including the late 1970s, when inflation-conscious investors pushed stock valuations too low, and the "Internet bubble" of the late 1990s. On the whole, the authors argue, financial markets value investments efficiently -- even if some people invest irrationally some of the time. Although managers may occasionally find ways to take advantage of short-term discrepancies, the authors say the only way they will be able to do so is by understanding the real underlying values.