These last few months have been troubling times if you cling to the quaint belief that there are facts and truths.
It is disconcerting to observe statements that are demonstrably false being made by senior political figures, covered and magnified by old and new media: and when those falsehoods are challenged, rather than apologise or back away, they and their followers double down, denying the falsehood or shifting the story. Where there are retractions, they are muted and receive minimal coverage.
In part, this results from a process of polarisation, perhaps most evident in the US, but which seems to be an increasingly pervasive feature of western economies. The fragmentation of news media and the rise of social media contribute here, since partisan outlets reinforce singular views and create echo chambers where claims are amplified and contrary views or questioning of claims derided. Shorter attention spans mean that sound bites crowd out more complete or nuanced discussion.
While this is evident in the political sphere, to what extent does it influence what happens in business and finance? There is evidence of impacts in retail markets. For example, recent research in the US[1] has shown that house prices react to flood risk more in areas with a higher proportion of climate change believers, while there is little reaction in areas dominated by climate change deniers – in US context, political allegiance maps well onto views on climate change. There is also evidence that consumer behaviour is influenced by political beliefs and the public stances of firms. These emphasise the importance of the behavioural component in individual financial decision-making.
However, are the insights of behavioural economics relevant to professional investment markets? Individual decision-makers sit within the context of their firm or fund, with colleagues, reporting lines, company rules, performance measurement and so forth. Those making sub-optimal economic decisions should not thrive in competitive markets. For individual behavioural traits, entrenched by polarisation, to have a systematic impact on market outcomes, then what are the mechanisms which might allow that to happen?
Recent corporate finance research from the US suggests that polarisation may extend into the boardroom. Research[2] is showing that firms are becoming more politically polarised, a trend that has accelerated rapidly from 2016 to the present (a period that has seen greater polarisation between the beliefs and attitudes of Democrats and Republicans). This extends, too, to non-executive directors. Increasingly, those with minority views within firms are more likely to leave and be replaced by those with views that conform to the majority.
In turn, this has real impacts on firm behaviour. Investment and capital budgeting decisions map onto political events – Democrat-dominated firms react to Republican victories at national or state level by adopting more risk-averse stances and vice-versa. This is not explained by policy differences favouring one type of firm and penalising another – it holds within sectors. Parallel work shows that the political and social stance of leading decision-makers affects other areas of fund and firm behaviour: political alignment maps onto adoption (or otherwise) of ESG policies across different firms; firm stances also map onto geographical location, consistent with the political colour of the state.
There are significant consequences of these findings for our understanding of the behaviour of firms and investors. Much of our corporate understanding is based on the underlying precepts of rational decision-making. Professional investors assess business opportunities, apply formal models to assess risk and return and select those projects that add to the value of the firm or fund. Those best able to make such decisions should thrive; prices should converge on their fundamental values in efficient markets. While we know that this will be violated at times (otherwise we wouldn’t have bubbles and crashes) the principle is embedded in business teaching and research.
Given the inherent uncertainty in markets, generally the framing of a decision will start with a general belief or view of the state of the world: this will be updated as new evidence arrived (formally, that is, we will assess the probability of an outcome as a Bayesian updating process). If firms (and social networks) are increasingly polarised, then that initial set of beliefs may be so firmly entrenched (and not subject to questioning) that new information may not lead to rational updating – anything that does not conform to the prior belief may be rejected. As a result, firms may react very differently to the same information. Where a belief set is strongly held across a sector, across firms, across funds, then this can lead to herd behaviour which, in turn, may diverge from economic rationality.
While I have framed this in terms of political polarisation, this staged process of a set of prior beliefs updated with new information has more general implications for investment behaviour, particularly in industries and asset classes where individual decision-makers play a more significant role: notably in private markets, where opportunities may be infrequent but significant in scale and in their impact on performance. This would be true of private equity or venture capital. It is likely to be true, too, of private commercial real estate markets.
Although we have limited formal evidence, we know that key individuals drive major acquisition and disposal decisions in property markets, even where there are formal processes such as investment committees and quantitative investment appraisal models (research for the Investment Property Forum showed that these were often overridden if the deal “smelled right”). These individuals can shape the underlying narrative that provides the context for individual decisions, that frames the search for opportunities. More junior workers have strong career incentives to adhere to that narrative.
We can extend this framework from firm to sector. One of the oft-quoted sayings about real estate is that “the property industry is a people industry”. The relatively tight social network can tend to reinforce a common narrative across firms, advisors and, indeed, investors. It is this that can fuel the herding that seems typical of much of the market, whether it is general (the balance between optimism and pessimism) or specific (preference for one type of asset over another – think beds and sheds). There is limited space for contrary views to be heard or acted upon – and the nature of the market makes it hard to exploit arbitrage opportunities that may arise.
I do not have a prescription to offer here, beyond a plea to examine both the underlying basis for the starting beliefs and the evidence available that challenges them. Research in venture capital suggests that investment committees with a culture of challenging and listening to diverse voices tend to make more successful decisions than those that are dominated by charismatic individuals. Maybe that is true in real estate, too?
[1] Baldauf, Garlappi & Yannelis, Review of Financial Studies, 2020.
[2] Notably by Elisabeth Kempf from Harvard and co-workers.
This article was originally published in the Summer Issue of The Property Chronicle.
