Financial Strategy, Second Edition

Section 1

Trends in Finance Theory

Section Overview

Janette Rutterford

The typical approach to teaching finance today is to cover the classic theories underpinning the subject area – portfolio theory, the Capital Asset Pricing Model, optimal capital structure and dividend policy, and the valuation of derivatives. The assumption is that managers behave – and have always behaved – in a way which these models predict. Finance theory now has a relatively long history and it is instructive to look at how management and investor behaviour has changed as finance theories have evolved.

The Trends in Finance Theory section to the book examines how finance theory has evolved over the last 100 years or more. The papers and cases in this section chart a trend away from a subjective and intuitive approach to finance problems a hundred years ago to a more rigorous modern approach to finance, with theoretical models backed by empirical analysis. This section also looks at a more recent development, behavioural theory, which takes a step back from theoretical models such as portfolio theory and the Capital Asset Pricing Model and tries to explain stock market phenomena which are anomalies in the context of efficient markets and rational investors.

The first article, “The World was their Oyster”, goes back to pre-World War I days to look at how British investors constructed investment portfolios. This was fifty years or more before Markowitz formalised portfolio theory and the concept of “optimal” ...