Impact of Daniel Kahneman and Michael Jensen on emerging markets

The works of Kahneman and Jensen will prod investors to critically reflect on the underlying framework of investment decision-making

In an age besieged by smartphones and portfolios of distractions, it is nothing short of a miracle to garner the unwavering attention of students in traditional finance classes; unless you are discussing the works of the late Daniel Kahneman and Michael Jensen. The world of finance and investments owes much of its fame, flamboyance, and flavour to the seminal works contributed by the two towering intellectuals, who passed away recently.

Kahneman revolutionised the way people perceived investments by challenging conventional wisdom congruous with the rational behaviour of investors. Kahneman resolved the jigsaw puzzle surrounding the behaviour of investors by formulating an investment thesis founded on investors’ irrationality in making investment decisions. In hindsight, the traditional financial wisdom rooted in the convention of efficient markets was disrupted forever.

The deluge of diverse styles of trading including the one famously monikered as ‘QUANTS’ owes its origins in behavioural finance. By dispensing with investors’ rationality, trading strategies are formulated for generating profitable trades breaking through the walls of efficiency and rationality.

Interestingly, Kahneman’s ground-breaking contribution has found its manifestation in foreign investors flocking to emerging markets (EM) enamoured not only by the prospect of high risk-adjusted returns, but also in their ability to extract profitable trades in markets deemed to be ‘inefficient’. The psychological demarcation between developed (efficient) and emerging (inefficient) markets remains at the heart of the investment philosophy implemented by nuanced institutional investors.

Even as fundamental strengths of an economy and other systematic factors remain critical, it is the investors’ underlying bias (or irrationality) that has translated into manifold success stories stitched by EM. In the Indian context, the unabated flow of flush foreign capital in recent times, despite their volatility, has inevitably played a role in pivoting India as one of the best-performing stock markets in the world.

On the other side, it is investors’ bias again that has kept some of the most promising markets in the African continent out of the portfolio. Kahneman would have blushed, knowing very well that investors are influenced by their irrationality.

Jensen’s work, too, had a significant impact in championing EM stock markets as unrivalled pockets of growth. By providing indisputable evidence on the excess returns generated by passive funds over active funds, Jensen’s theory is prominently evident in metrics like the Sharpe ratio capturing a fund’s excess returns over risk-free rate on risk-adjusted bases.

Seen from the Indian context, it wouldn’t surprise investors that between 1991 and 20204, India’s benchmark index, S&P BSE SENSEX generated an eye-popping total return of 3,890 per cent implying Rs 10,000 invested in 1991 would have grown to Rs 3,88,968 in 2024 with an impressive compounded annual growth rate (CAGR) of 11.73 per cent. No wonder, the surge in mutual funds and systematic investment plans (SIP) tied to the returns of the broader market are garnering significant attention from retail investors in India, who generally tend to be risk averse.

Even as students and scholars of finance savour the duo’s intellectually stimulating theoretical models, their contribution in propelling the rise of EM as bastions of returns remains undisputed. Most significantly, their pioneering work should also trigger stimulating dialogue in the traditional classification of developed markets vs EM. At least in the post-pandemic scenario, the lines of demarcation between the two are increasingly getting blurred as the former confronts the twin challenges emanating from inflation and banking woes.

Even as EMs continue to extend their dominance, there is significant work to be done on governance as fundamental factors, including fiscal and monetary prudence to remain important to the investors’ irrationality and passivity.

Kahneman and Jensen may not be seen as a panacea for all investment woes, but their works retain relevance by prodding investors to critically reflect on the underlying framework of investment decision-making. Till then, markets will be seen as inefficient, and investors’ behaviour as irrational.

(Ullas Rao is Assistant Professor of Finance, EBS Dubai. X: @Ullasrao7.)

Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.