While well-diversified shareholders prefer that managers ignore diversifiable risk in selecting investment projects, managers may behave otherwise because of their high personal exposure to company-specific risk. This can result in too conservative an investment policy that ultimately reduces shareholder value. I mention this to question the conventional wisdom that compensating executives with company stocks and options aligns the interests of shareholders and managers. While both prefer higher stock prices, they may strongly disagree about what types of risk should be avoided.

In the case of small business owners with majority equity stakes, the caveat is that textbook methods to estimate the cost of capital may not lead to the right answer. Models like the CAPM are premised on the idea that companies have well diversified shareholders who don’t care about the specific risk of the company. To the extent that companies are closely held, traditional theories are likely to understate the cost of capital by neglecting an important component of risk. Unfortunately, I know of no formula designed to correct this problem. Unless such tools are developed, small business owners will have to rely on the standard theory and subjective judgments in assessing their cost of capital.

In an efficient market, if relevant market prices are available, they should be a manager’s top pick out of the valuation toolbox. Why focus on market prices? Again, it is because they offer a free, broad-based opinion on an asset’s value. When managers ignore the information in prices, large and costly mistakes can occur. The most striking evidence is found in the literature on mergers and acquisitions. On average, an acquiring firm pays a substantial premium over the market price for the firm they are acquiring. Analysts prepare page after page of discounted cash flow analysis to justify the high valuations, along with appeals to operating efficiencies or other synergies that would seem to make the target very valuable. But the evidence shows that, on average, acquiring firms overpay and value is destroyed – losses to the stockholders of acquiring firms more than offset the gains to the stockholders of takeover targets. Market prices, it seems, are a better indicator of the value of takeover targets than the detailed studies of investment bankers.

Often market prices are not available, or they are clearly inapplicable to the situation at hand, as in most capital budgeting exercises. In this case the method of discounted present-value analysis is an essential valuation tool that also has its origins in market efficiency. It disciplines investment decisions by forcing managers to carefully assess the likely value added of a prospective investment, and provides a framework to examine key sensitivities. It incorporates the preferences of a company’s stockholders via the choice of the discount rate. The technique involves first projecting all future cash flows that are attributable to that project. This includes any indirect costs or benefits, such as the opportunity cost of using a facility that could otherwise be used elsewhere or sold. The idea is to set the cash flows to a realistic level, not optimistic and not pessimistic. The appropriate risk-adjusted discount rate also must be identified. A project is deemed worthwhile if the present discounted value of cash flows is positive, and is said to have a positive net present value (NPV). In an efficient market, the estimated NPV represents the best estimate of the effect of the project on firm value.

Even though discounted present value analysis is a relatively straightforward technique in broad outline, applying it effectively can be a challenge. Some people feel that projecting cash flows into the indefinite future involves so much speculation, and that the right discount rate is so uncertain, that the resulting estimates are too imprecise to be useful. The question though, is whether there is a better choice. Certainly it is better to have an imprecise estimate of value than no estimate at all or one that is based on an overly simplistic rule of thumb. In the end all investment decisions are subjective, but numbers help to inform judgment and point to potential flaws in purely intuitive evaluations. Explicitly identifying expected future cash flows allows analysts to test the sensitivity of value estimates to these assumptions. Maybe your best guess is that cash flows will grow at 8 percent per year after ten years, but will the project still be worthwhile if the growth rate is only 6 percent? The only way to tell is to lay out alternative assumptions about cash flows and discount rates, and see whether, over a reasonable range of assumptions, a candidate project still appears to be worthwhile.

Some analysts use multiples as an alternative to present discounted value analysis. The idea is that comparable companies should trade at comparable multiples. If, for instance, most computer manufacturers trade at multiples of 20 times earnings, then a company trading at 25 times earnings would appear to be relatively expensive, unless some additional source of value can be identified. This type of analysis rests on the questionable assumption that companies in similar lines of business are in similar positions with respect to earnings and value. It also skirts the question of whether the general level of prices is reasonable. This problem was made abundantly clear with the crash of Internet stocks. Internet stocks were often evaluated in terms of multiples, in part because it seemed impossible to predict when positive cash flows would actually appear. A discounted present value analysis would have identified the lack of foreseeable cash flows as a red flag, but multiples analysis de-emphasizes this problem by focusing primarily on relative value.

For firms that rely on discounted present value analysis, correctly identifying the cost of capital is critical. It is a major determinant of which projects a company will take on and which it will reject. If the rate-of-return hurdle is set too high, managers will pass up profitable investments. If it is set too low, value- destroying projects will be accepted. There are several important considerations to keep in mind in determining the cost of capital.

The first rule is that a project must be evaluated based on a discount rate that reflects how much market risk is associated with it. For a public company, its diversifiable risk is generally not a concern. This rule for choosing a discount rate follows from market efficiency. As discussed above, in an efficient market, diversified investors, whose concern is primarily with market risk, determine share prices. Managers acting on behalf of diversified investors must therefore evaluate whether the expected return is commensurate with the type of risk investors care about. In practice, market risk is usually quantified using a financial model such as the Capital Asset Pricing Model (CAPM). The model provides an estimate of an investment’s “beta,” a measure of the amount of market risk. Some managers make these estimates themselves, while others use the services of a financial consultant. The details of the CAPM and related models are beyond the scope of this essay, but a comprehensive discussion can be found in any modern finance text.

A related principle that is too often overlooked is that the relevant market risk is that associated with the project under consideration. This may be very different from the overall risk of the company. The idea is that the project should be evaluated based on the amount of market risk it contributes to the company at the margin. For instance, if a company that is primarily in the aerospace industry has the opportunity to invest in a supermarket chain, the cost of capital for that project is the one associated with supermarkets, not aerospace. The logic is that investors in an efficient market view companies as a portfolio of all their investments. They therefore require a weighted-average return that reflects the relative importance of each component. If the company consists of 70 percent aerospace, 20 percent electronic components, and 10 percent supermarkets, investors will require a return reflecting the cost of capital for aerospace, electronic components, and supermarkets, with weights of 70 percent, 20 percent, and 10 percent, respectively.

Notice that in describing the determinants of the required rate of return, there has been no mention of how the project is to be financed. This is deliberate. The reason that financing can be neglected is also attributable to market efficiency. Investors in a company’s debt and equity require different rates of return because the two types of investments have very different amounts of market risk. Debt, with its first claim on any cash, carries significantly less risk than equity. A firm’s assets, however, tie down its total amount of market risk. This total risk is conserved, no matter how it is split between debt and equity. Even though debt holders require a lower return than equity, a firm cannot necessarily lower their required rate of return by issuing more debt. Taking on additional debt makes both the debt and the equity of the firm riskier, increasing the required return on both debt and equity.

Serious mistakes can result when companies fail to take these valuation principles into account. Several years ago, an executive MBA student in Thailand told me that his company was getting loans from its Japanese parent company at a rate close to zero percent. As a result, the management considered its cost of capital to be almost nil, leading them to adopt some very marginal projects. The problem with management’s logic was to equate the required return on debt with the overall required return, neglecting the considerable risk borne by stockholders. Companies that invest in risky projects can never have a cost of capital close to zero, even if they can borrow at a very low rate. If other Japanese companies were similarly underestimating their cost of capital, this may be one source of the continuing problems plaguing the Japanese economy.

Investors, anticipating the possibility of default, drove down the price of United’s bonds to the point where the risk and expected return were in line.

Another example of the strong tie between risk and return is the experience of a Minneapolis-based money market fund, which for years proudly advertised their record of superior performance. Their success was perplexing: Money market funds, with their strict guidelines for safe investment, generally lack the latitude to significantly outperform their competitors. The puzzle was solved when it was learned, following catastrophic losses, that the manager had hidden derivative investments. Market efficiency implies that investments that look too good to be true probably are.

In determining the relation between risk and required return, financial theory distinguishes between two different types of risk: diversifiable (or idiosyncratic) and market. The theory states that investors will be compensated for market risk, but not for diversifiable risk. Most investments have elements of both types of risk. Market risk arises from common factors, such as business cycle fluctuations, and affects almost all assets to varying degrees. Diversifiable risk is not correlated across assets, and, as its name suggests, it can be eliminated by diversification. It is the nature of diversifiable risks that when one asset has a higher than expected return, another is likely to have a lower than expected return. Thus those risks cancel out in a diversified portfolio. In contrast, market risk cannot be eliminated by diversification because it affects all assets simultaneously in the same direction.

Finance theory states that investors are compensated only for market risk, not for diversifiable risk. Market efficiency is a key ingredient to this conclusion. The idea is that astute investors recognize that some risks can be diversified, and hence accept these risks without extra compensation as part of a diversified portfolio. These diversified investors bid up the prices of assets with idiosyncratic risk until prices reflect only market risk. As a result, undiversified investors will find themselves bearing idiosyncratic risk without any compensation for it. This line of reasoning also makes clear the importance of diversification. In an efficient market diversification is essential to ensure investors returns commensurate with risk exposure.

In the face of a stock market bubble like the technology bubble in the late 1990s, some efficient-markets proponents would argue that investors should not alter their investment strategies one bit. After all, even if prices appear too high to explain, other investors are also aware of this. Expected returns are still positive because otherwise investors would sell. There is no telling when the bubble will burst. On the other hand, a second cornerstone of financial theory is that stock prices (like the prices of all financial assets) are ultimately tied to fundamentals, that is, to cash flows. If prices are many times higher than any reasonable expectation of future cash flow can justify, this suggests investors are taking a much greater risk than in normal times. Investing in a bubble is a bet that someone will come along and buy a share of stock from you at a price that is even further out of line with fundamentals than the one you paid. This cannot continue indefinitely; the resources of the real economy ultimately limit the value of the market. Eventually market participants must come to their senses and prices must return to earth. It is reasonable, then, for investors with a limited taste for risk to sit out bubbles, shifting their money to less speculative investments. (Readers interested in further exploring this viewpoint are directed to the writings of Professor Robert Shiller of Yale University.)

For many investors diversifying is simple. It involves investing in a broad-based stock index fund and other asset classes, such as real estate and bonds, with the portion devoted to each asset class reflecting an individual’s taste for risk. For some investors, such as top executives and owners of small businesses, the optimal diversification strategy is not so straightforward. In the last few years my colleague, John Heaton at the University of Chicago, and I have been studying the question: Is standard portfolio theory an appropriate prescription for investors who are forced to invest heavily in their own companies? Typically, corporate executives receive company stock and stock options as part of their compensation package. This provides an added incentive for managers to act in the interest of shareholders. Small business owners similarly hold a substantial portion of their wealth in their own companies. A cost of this practice is that entrepreneurs and managers are exposed to considerable risk with few outlets for diversification.

If you have no choice but to invest heavily in your own company, as is the case for many wealthy people and even some workers, placing your unrestricted savings in the market portfolio is unlikely to maximize the benefits of diversification. There is the potential of further reducing your risk by judiciously choosing investments that will tend to perform well when your company is faltering. This is consistent with the basic logic of diversification that certain risks tend to be offsetting.

Consider an executive at General Motors who is heavily exposed to GM risk. Not only does her job depend on the fortunes of GM, but she also holds a large portion of wealth in GM stock and options. If she also invests her unrestricted savings in a diversified stock portfolio, it will include the stocks of Ford, GM, Chrysler, and other car companies. This increases her overexposure to auto industry risk. A well-structured diversifying portfolio would avoid investments in the auto industry or might even involve taking a short (i.e., negative) position in the stock of other automobile manufacturers. Similar considerations apply to employees forced to hold retirement savings in the form of own-company stock. Those workers not only face the undiversified risk of losing their jobs, but they also risk simultaneously losing their retirement savings. A sad but not uncommon example is the case of Enron, where employees find themselves with no jobs and little or no savings. Diversification for workers means holding their savings in portfolios that avoid own-company stock.

These examples lead to the conclusion that many people could further reduce their risk exposure by thinking about what diversification means in their personal situations. Taking this approach, one would generally start with a diversified market portfolio and then add or subtract particular stocks so as to hedge the risks from restricted stock holdings or job loss. While sophisticated investment managers already employ such strategies on behalf of high-end clients, I am optimistic that a broader awareness of this issue will eventually be used to help a much broader

Some market observers strongly reject the notion of market efficiency – they are attuned to the psychology and idiosyncrasies of the market and are convinced there is money to be made. While I believe a few talented individuals may have the ability to spot emerging patterns and exploit them effectively, the weight of several decades of empirical research supports the idea that markets are reasonably efficient. From the perspective of individual investors, perhaps the most important evidence comes from the studies on mutual fund performance.

If it were possible to regularly exploit pricing mistakes, mutual fund managers, whose job is to look for under-priced assets, should be able to beat a passive investment strategy, such as investing in the S&P 500 stock index. As it turns out, on average, mutual funds under-perform passive index strategies by a significant margin when fees and other transaction costs are taken into account. Active managers trading frequently under- perform relative to passive managers avoiding excessive trading costs. Load funds under-perform relative to no-load funds, meaning investors who pay more for help don’t get more in return. Still, one might wonder, even if the average financial manager cannot generate value, why not invest with a financial manager who can? Unfortunately, finding a manager who can consistently beat the market is as difficult as beating the market on your own. Market efficiency applies to managers, as well as to markets. Competition for the services of any manager capable of generating above market returns should leave the manager, not investors, with any excess profits.

In an efficient market the best investment strategy for most people is to hold a well-diversified portfolio, tailored to reflect individual risk tolerance, tax status, liquidity needs, etc. (As explained below, diversification usually guarantees the lowest possible risk for any target level of return.) Since competitive forces mean prices are about right, then you do not need to spend long hours analyzing investment alternatives, and there is no reason to pay an expert for trading tips. An efficient market allows investors the luxury of being lazy. It is important however, to occasionally reevaluate whether your portfolio reflects your risk tolerance, whether it is optimized for your tax status, and so forth. For many investors the advice of investment professionals is helpful in evaluating these alternatives.

A largely passive approach to personal investing strikes many people as counterintuitive. Business professionals know that careful analysis is critical to making sound investment decisions.

But there is no contradiction here. While the burden falls on individual managers to evaluate business investments, for publicly traded securities the opinions, and often careful research, of a much larger group of investors are already reflected in asset prices. This greatly reduces the value of gathering additional information and frees investors from the need to do so when market prices are available.

Simply put, an efficient market is one in which information – good or bad – is quickly reflected in the market prices of financial securities. Prices represent the current consensus about fair value. This is not to say that prices at every moment are right in any absolute sense; the theory simply implies that most people cannot identify the direction or duration of any error. The idea is compelling because it follows directly from the observation that when many smart people try to exploit any new information as it hits the market, their trades tend to push prices to a level that is hard to second guess. Investors competing to exploit profit opportunities ensure that few such opportunities exist. Market efficiency therefore serves as a caution to investors not to expect a free lunch.

The theory of market efficiency is commonly divided into three distinct hypotheses: strong form market efficiency, semi-strong form market efficiency, and weak form market efficiency. The type of information assumed to be reflected in market prices distinguishes between these theories.

Strong form efficiency says you can’t make money by simply studying the history of prices – current prices already reflect any information that could be inferred from price histories. Semi- strong form efficiency goes further and states that all public information, such as company press releases, accounting numbers, and macroeconomic data, is fully reflected in current prices. Advocates of either weak or semi-strong form market efficiency concede, however, that insiders and other people with private information may be able to profit from their informational advantage. The strong form hypothesis pushes the idea of efficiency to the limit. It says that all information, even private information, is reflected in market prices. The idea is that insiders, in the process of trading to exploit their informational advantage, quickly reveal what they know through the effect of their trades on prices. The weight of empirical evidence supports weak and semi-strong form efficiency – the idea that public information is quickly reflected in prices; this is what I mean when I speak of market efficiency here.