Behavioral and Value Investing
Course Number 1495
Professor Robin Greenwood
Professor Malcolm P. Baker
Winter; Q3; 1.5 credits
Note to students enrolled in both 'Behavioral and Value Investing' and 'Investment Strategies': While there is no overlap in the cases taught in the BVI and IS courses, a few basic concepts appear in both courses. Students may enroll in both courses.
Capital markets are not efficient in the way that textbook theory suggests. Through their trading behavior, biased individual investors and rule-bound institutions can cause prices to deviate significantly from fundamental value. These deviations create opportunities and risks for sophisticated investors. The first part of the course develops a framework for understanding what drives deviations from market efficiency. This covers the two building blocks of behavioral finance: investor psychology and so-called limits-to-arbitrage. The second part of the course - value investing - is focused on identifying and measuring these deviations in practice. The course takes a broad view of value investing. This means that we will cover many of the traditional ideas emphasized in early treatments of value investing - such as the concept of franchise value - while also covering situations in which the broader themes of behavioral finance can help us make better investments. The applications studied in the course appear in markets in the U.S. and abroad.
BVI is primarily intended for students who plan to pursue a career in investment management and research. The course also serves students who plan to work in private equity, or in corporate finance roles where they expect to have regular interactions with the capital markets. In addition to the key behavioral finance concepts, students will develop and reinforce a set of analytical tools used for evaluating strategic and investment decisions.
Part I of the course develops the foundational theory of behavioral finance, split into two modules. In the first module, we explore errors in human judgment. We also discuss institutional rigidities which appear to be errors in judgment (such as soft rules requiring some investors to hold investment grade bonds). The second module is devoted to "limits-to-arbitrage" - the set of institutional arrangements that allow human biases, expressed as misplaced security demand - to influence prices. The combination of behavioral biases and limits-to-arbitrage creates patterns of systematic mispricing that can be exploited using a variety of trading strategies. Cases at the end of the second module explore the performance of these strategies.
Part II is focused on applications, with a particular emphasis on modern value investing. This last module has two broad objectives. First, how does one identify situations, in practice, where misplaced investor demand has caused prices to deviate from fundamental value? Second, in cases where we suspect that the market is inefficient, how do we evaluate what fundamental value is?
We will rely on a combination of cases, readings and exercises to motivate class discussion. Because of the rich intellectual tradition behind value investing, we will be reading some older texts as well as some modern academic treatments. While we will draw from these readings in class, there will not be time to discuss all of them. We will set up a value investing discussion board, with readings for each week: here you may pose questions and/or offer your thoughts.