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B. Venkatesh

CONSIDER this. Your friend asks you why Infosys trades at Rs 1,900. You explain that a stock price reflects a company's "fundamentals". That is, the stock price is a function of the company's revenues and EPS. Studies in behavioural economics, however, suggest that we do not value goods (including stocks) based on "fundamentals". Instead, we assign values based on a behaviour termed as Coherent Arbitrariness. What is this behaviour?

Professor George Lowenstein of Carnegie Mellon University coined this term based on a series of experiments that he conducted with two MIT Profs. The basis of this experiment was the 1974 study by behavioural psychologists Kahneman and Tversky.

These psychologists spun a wheel of fortune with numbers ranging from 0 to 100. The subjects were asked if the fraction of African countries in the UN were less or more than that number. The subjects used the number spun on the wheel as the reference to guess the answer!

Lowenstein and his co-authors similarly provided some reference values to their subjects and then asked them what compensation they would require to hear an unpleasant sound for certain duration. The subjects quoted arbitrary values linked to the reference values.

The professors then asked the subjects the price they would want for longer duration. The subjects quoted values that there consistent with the initial price. That is, if a subject demanded Rs 100 for one minute, she demanded Rs 200 for two minutes.

As the initial price is arbitrary and the subsequent price consistent with the initial price, the behaviour is termed coherent arbitrariness.

Economists argue that we buy stocks the same way! Your decision to buy Infosys at, say, Rs 1,900 may be arbitrary, while the subsequent buy/sell decisions will be strongly anchored to this price.

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