Even though a firm’s managers can be expected to know more about their operations and business prospects than outsiders, they never have complete knowledge — some outsiders will know things the managers do not. The market, the authors write, “aggregates the information of many speculators who collectively may be more informed” than the managers are.
Other players also benefit from the feedback effect because they don’t have the inside view that managers do, Goldstein and his colleagues write. “Credit-rating agencies are known to be influenced by stock prices, and their decisions have a large effect on the availability of credit to the firm. Regulators, who take actions that affect firm cash flows (most prominently, in the case of banks), follow market prices very closely…. Similarly, employees and customers may base their decisions on whether to work for the firm or buy its products on information they glean from the market.”
Managers whose compensation is related to the stock price through bonuses, stock options or other ties will base decisions on their potential to affect the share price. Tying compensation to share price is a way to discourage “agency problems,” where a manager puts his own interests ahead of shareholders’.
“Shareholders choose to solve agency problems with the firm’s manager by tying his compensation to the stock price, because they believe that the stock price contains information about firm value,” the authors write. “If prices were uninformative, shareholders would not tie managerial compensation to stock prices, and so managers would not care about them.”
Irrational traders
In the traditional view of market efficiency, it is assumed that investors digest all information available about a company and, through the push and pull of supply and demand, arrive at a price that reflects the firm’s true value. But research has shown that various forces can interfere with this process, and Goldstein and his colleagues point to a number of examples, such as the “survival of irrational traders.”
“Under the traditional view, irrational traders, who trade based on considerations unrelated to the firms’ fundamentals, will lose money and hence disappear from the market over time,” they write. Therefore, “markets will be populated only by rational traders, and so prices will be efficient, correctly reflecting firms’ fundamentals.”
But the feedback process can allow irrational traders to survive, because their views can actually affect the firm’s cash flows and create a self-fulfilling prophesy. A flood of positive views among traders, even if they are irrational, can raise the share price by enhancing demand, make the firm look healthier and encourage management decisions that otherwise might not be made. Irrational traders may therefore make money rather than lose it, and survive to trade another day. “This again demonstrates that traditional definitions of market efficiency may lack relevance when feedback from prices to decisions is important,” the authors write.
