Tuesday, October 28, 2008

Toward A New Valuation Model

Approximately five years ago at a meeting with many of the leading behavioral finance thinkers, I asked the following question: "When will behavioral finance produce the successor to the centerpiece of the rational investor efficient markets theory - the capital asset pricing model?" The answer from one of the leading lights in attendance was ten years. If true, we are only half way toward a key component of finance, a component that is sorely needed as the valuation model used by nearly every traditionally-trained investor is broken.

For most investors bound to a methodology that hasn't made much sense for decades, the path ahead is a highly uncertain one. Company analyses and portfolio management tools and processes are anchored in the ancient art of the efficient market hypothesis and its central equity valuation tool, the capital asset pricing model. To retool established, well entrenched ways of doing business will not be easy for those locked in the ways of the past.

In a recent CFA Institute meeting, PIMCO Co-CEO and CIO, Mohammed El-Erian, brings to light many of the issues that all investors need to think through, especially those whose livelihoods depend on managing other people's money. Mr. El-Erian's speech renders advice that investors should "think the unthinkable" and brings the credit crisis into full valuation and financial modeling view as he places the recent crisis in context.

To listen to his insightful and unnerving views, click here.

Investment Strategy Implications

The behavioral finance clock is ticking and its arrival cannot come too soon for a new world economic order that cannot effectively proceed without the necessary evolution in valuation modeling. And as it does occur, investors who position themselves to take advantage of our brave new economic and financial world to be will reap the benefits.

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