Fusion investing attempts to integrate traditional and behavioural paradigms to create more robust investment models.
Fusion investing is the integration of fundamental value and investor sentiment. Although financial literature treats fundamental valuation and behavioural finance as divergent approaches, there exists an important association between the two. Let us understand the concept of fusion investing as a common investor.
In the traditional approach, the intrinsic value of a company is defined as the present value of its expected cash flows such as the dividend and or expected price at the end of the holding period to shareholders. This present value is a function of the information set available in the market. This is based on the theory known as efficient market hypothesis. Investors believe that stock price adjusts according to the available information immediately. So, prices adjust quickly but not in an unbiased manner. For instance, a positive earnings surprise precedes a positive price drift.
The behavioural finance literature has suggested an alternative to the traditional view of markets. Accordingly, only two types of investors exist in the stock market. One is the informed trader and the other is the noise trader. Informed trader does valuation analysis, such as discounted cash flow computations, to calculate the present value of the future cash flows whereas the demands of noise traders are motivated by whims, rather than serious valuation analysis.
Noise traders have time-varying demands that are not based on an optimal forecast of expected returns for a stock. The noise traders often push stock prices great distances away from their intrinsic values. In the words of Benjamin Graham, the father of value investing style, “in the short run the market is a voting machine, and in the long run it is a weighing machine”. So, fusion investing is the investing style aimed at profiting from understanding both the voting and the weighing.
Fusion investing style
Fusion investing is a relatively new approach which started during the early 2000s, which attempts to integrate traditional and behavioural paradigms to create more robust investment models. The term, fusion investing, was first presented by Lee where he proposed that share valuation could be done by incorporating behavioural finance aspects.
How it works
As an investor one should choose,from the population of all shares, those considered value shares. From that lot, those that are fundamentally sound should be selected and finally those stocks which exhibit winning momentum characteristics should be chosen. The first two stages are evaluated on an annual basis whereas the final stage is evaluated monthly.
As firms release financial statements annually, any significant information contained in this release would cause the firm’s share price, as well as related data, to change in the long term. The inclusion of a monthly momentum stage should be effective in capturing short-term fluctuations present between releases of financial statements. Thus, any share that passes all of the above three criteria is considered inexpensive, financially sound and has positive prior performance.
To conclude, fusion investing attempts to integrate traditional and behavioural paradigms to create more robust investment models. Some investment styles have a record of producing respectable long-term results. Even the most successful styles and strategies sometimes experience extended dry spells. Indeed, styles that pay off in one economic environment may fail in another one.
The writer is a professor of finance & accounting, IIM Tiruchirappalli