Investment Theory: Behavioral Economics, Capital Flow Analysis, and the Motivation Axiom
Investment Theory: Capital Flow Analysis
The Motivation Axiom
The purpose of Capital Flow Analysis is to explain security price trends. To do this, flow tables must be read with reference to security prices.
Looking at table F.2XX, below, without reference to the price trend of Security 'A' during 'year 1', we can only conclude that the net amount sold by the issuer was the same as the net amount bought by the investor.
This is not very helpful.
We need to know who was driving the market: the issuer or the investor?
F.2XX Security 'A' |
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Price Trend |
? |
Year 1 |
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Issuer: |
200 |
Investor: |
200 |
Price Trends Provide The Key
If we know that security prices were rising during 'year 1' (the next table, below), we might conclude that the investor was more anxious to buy than the issuer was to sell.
Assuming that the supplementary information was the same as in the tables in Lesson 1, we would note that the investor was buying on margin.
This would suggest that rising prices were a speculative run-up.
From supplementary tables in Lesson 1, we would also see that the issuer had been taking advantage of higher prices to sell additional shares, raising funds at lower cost of capital, in order to finance long-term growth.
F.2XX Security 'A' |
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|---|---|
Price Trend |
UP |
Year 1 |
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Issuer: |
200 |
Investor: |
200 |
With Different Price Trends, Interpretations Change
However, if prices were falling (the next table, below), we might conclude that issuers were desperate to sell stock, perhaps to finance long-term growth, at a time when investors were reluctant to buy.
In such a scenario, the investor's purchases on margin might indicate that falling prices were seen by investors as a buying opportunity.
F.2XX Security 'A' |
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|---|---|
Price Trend |
DOWN |
Year 1 |
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Issuer: |
200 |
Investor: |
200 |
The 'color' given to the flow of funds data by security price trends is vital in Capital Flow Analysis.
This price information leads to the first rule of Capital Flow Analysis: 'The Motivation Axiom'.
The Motivation Axiom
The Motivation Axiom seems to be commonsense, but, as we shall see later (Lesson 6), this rule is contrary to some current economic theory.
The Motivation Axiom is as follows:
Unequal Motivation Controls Market Price
In investment transactions with respect to a class of securities, the intensity of motivation of buyers and sellers is rarely the same.
When sectors that are buying are more motivated than sectors that are selling, the price of the class of securities will rise, and the opposite occurs when selling groups are more motivated than buying groups.
This axiom refers to standardized groups of buyers or sellers (such as sectors in flow of funds accounts).
Sectors are deemed to be buyers or sellers, based on the net movement in the flow tables.
We simplify analysis by thinking of each sector as persons acting in concert, with parallel motivation leading to a common result.
Each group of players includes thousands or even millions of persons that, on balance, are either net buyers or net sellers of a general class of securities.
The term ‘class of securities’ refers to flow of fund instruments such as equities, bonds, mutual funds, or mortgages.
The price and flow data may span from three months to decades.
What Is Motivation?
Motivation is defined as,
‘a reason for doing something or behaving in some way.’
The reasons that explain behavior of so many over such long periods are not transitory whims or selfish impulses of individuals.
The stuff that moves billions of dollars of capital over many quarters or years is hardly anything so unsubstantial as ‘investor confidence’ or fluctuations in interest rates.
In Capital Flow Analysis, we need to discover deep-rooted imperatives that govern groups and societies, evidenced by laws, institutional structures, widely held beliefs, culture, and the framework of organizations.
We need to understand the impact of tax regulations, corporate law, business habits, and other issues that differ from sector to sector.
Price Is Not A Function Of Quantity
Capital Flow Analysis explains asset price movements not as a function of the quantity of securities offered for purchase or sale, but as a result of opposing motivation of different categories of market players.
Price is a clue in deciding the nature of this motivation.
This is different than the classic 'price-quantity' diagrams used to teach supply and demand in Economics 101.
Most security prices are determined in secondary markets in which potential 'supply' is thousands of times greater than the amount actually traded on the securities exchange.
There is no practical way to measure changes in the 'quantity' of securities offered or sought that would be useful in determining price.
Although economists may insist that the classic price-quantity graphs are relevant, for practitioners making decisions in real securities markets, these curves are not helpful.
Mutliple Motivation
For a particular investment instrument, there are usually several sectors buying and selling.
To understand price movements, we need to evaluate the motives of each sector.
We must try to discover the reasons why each sector holds or disposes of specific classes of investments.
Furthermore:
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Each sector works under different ground rules.
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Investors and issuers are not playing the same game.
Showing Motivation in Color-Coded Tables
When analyzing flow of funds accounts, it is important to be able to identify the sectors that are buyers and sellers and to know which groups are motivated (according to the Motivation Axiom) and which are not.
This can be a little tricky, since sometimes issuers have negative issues, while investors have negative purchases.
To help interpret the flow tables properly, we use color-coding.
It is easy to misread the flow tables.
In order to read the table correctly, you must be able to figure out which sectors are buying and selling and use this information together with price trends for that type of security over the period.
The color-coded tables on this site make it easier to do this.
If you have not read the module on the explanation of color-coding, 
, please do so before going to the next lesson.
Before proceeding, check your progress:
Self-Test
The key to determining motivated buyers or sellers is:
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According to the Motivation Axiom, prices rise when:
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Motivation is defined as:
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Multi-Player Markets : continued >
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Bias, overconfidence, and emotion cloud the minds of investors. |
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Mega-mistakes of business leaders |
