After the MBA or Erroneous Assumptions of Value

Over the last few weeks, I’ve recalled a question I’d asked while learning about the “Capital Assets Pricing Model” in Finance I : mightn’t erroneous assumptions about the worth of an asset’s terminal and liquidation values distort the present value of an investment? My professor suggested that the question was subversive. Dutifully, though, on the way to the MBA, I put pencil to paper and completed the exercise. Got it right.

Wrong. Over the last few weeks, with everyone rattled by terrific market turbulence--- portfolio values rapidly eroding despite advisors’ adherence to portfolio balance, and corporate betas suddenly meaningless--- I thought back to that exercise. How our models are based on rational assumptions, neatly aligned with the normal curve and its orderly rules and regulations. Despite our desire to domesticate the irrational, markets aren’t so acquiescent. Their participants aren’t only programmed trading protocols--- but the people behind them, experiencing or envisioning loss, ruin, and panic. Behavioral finance has had much to say about market irrationality and the dangers of our defensive beliefs in prediction and control: what we want to believe about our influence in the world.

Even wild fluctuations in returns look smooth if you take the data back far enough. Up close- next to those few violently oscillating market days that swing markets up and down- I’m reminded of B. Mandelbrot’s observation that volatility predicts volatility, with no indication of direction. This is an idea affirming our need for prediction, though stripped of our need for control. One out of two isn’t bad: knowledge of what we don’t know may be more valuable than knowledge of what we do.

Fluctuation describes the emergent shape of things as they play out in our lives, rather than in our fantasies: its not only that passions alternate to their opposite—its also that elevations suddenly evaporate. The brilliant capability of yesterday becomes negligible today: a market truth. The “high potential” executive trainee, on-boarded, coached, and ascendant, is suddenly laid off. Where does the “potential” go?

There are two answers, both linked to that question I’d asked about CAPM in Finance I. Empirically, in the tumult of organizational and social change, the terminal value assumption is faulty: value is easily discarded, written down. The glass is half empty. And in the stampeding panic, may even be crushed ( I notice that the stock of a company producing the bottle of soda water in front of me, sold last week for less than the cost of the soda itself).

It’s a harder act to ride out the emotional volatilities with which we resonate, influenced by the turbulent environments in which we live, and to affirm the assumptions (however misguided in their original form) learnt in b-school: that assets remain. Its up to us to transform them creatively. That is --- potential endures. It takes continual cultivation, though, of what psychologists term, “hardiness”, as we are acted upon by external volatility which we seek to escape . Fleeing markets where volatility but not control is predictable , we only contribute to increased market volatility ---and speed the feedback that undermines our internal sense of security.