[HSO]

> There is only one thing being valued by a rational investor: net present value of future cash flows.

This only holds under the assumption of rational expectations.

Under the more reasonable assumption of heterogeneous expectations, it becomes necessary to think about what the market on average expects (or, possibly, other functionals of the agent population if the assumption of competitive markets is violated); the more so the shorter your investment horizon.

See for example

[1] F. Allen, S. Morris, and H. S. Shin. Beauty contests and iterated expectations in asset markets. Review of Financial Studies, 19(3):161–177, 2006.

which shows the failure of the law of iterated expectations (which is used to establish your original assertion) for the average expectations operator.

You then have

[2] P. Bacchetta and E. Van Wincoop. Higher order expectations in asset pricing. Journal of Money, Credit and Banking, 40(5):837–866, 2008.

who derive a gap between price and fundamental value (understood as the NPV formula that would prevail without the interference of higher-order beliefs) in the presence of heterogeneous expectations.

And last but not least,

[3] M. Kurz and M. Motolese. Diverse beliefs and time variability of risk premia. Economic Theory, 47(2-3):293–335, 2011.

who generalize this from the asymmetric information frameworks used above, where expectations are coordinated by the public signal, to a symmetric information setting where it is the correlation of beliefs that coordinates expectations.

In the end, this is all building on Keynes's original intuition that if agents hold diverse beliefs about the future "the energies and skill of the professional investor and speculator are […] concerned, not with what an investment is really worth to a man who buys it ‘for keeps’, but with what the market will value it at."

So no, it is not necessarily the best strategy to only focus on NPV of cash flows. The shorter your time horizon, the more you depend on what "other people" expect too, whether you think them foolish or not.

_____________________

PS: Of course, if you believe that you have no predictive power w.r.t. what "Mr. Market" thinks (to borrow from Ben Graham's exasperated simile), then by all means your optimal strategy becomes to lengthen your horizon as far out as possible and concentrate only on NPV of cash flows, just as you said, in the spirit of value investing. I'm only pointing out that the optimality of this strategy hinges on both your investment horizon and your belief about your relative predictive powers w.r.t. "Mr. Market" and the fundamentals (leaving aside positive feedback loops or what Soros called "reflexivity" between price and fundamentals for now).

[yummyfajitas]

Rational expectations and heterogeneous expectations don't conflict with each other. Rational expectations only assumes that the aggregate expectation of the economy is an unbiased predictor.

Individual agents are free to be irrational, biased, and heterogeneous. In fact, heterogeneity is required in nearly any model, otherwise no trades will occur.

[HSO]

> Rational expectations and heterogeneous expectations don't conflict with each other.

Good point, although I didn't say they did. One can indeed view RE as a special case of heterogeneous expectations, and in fact that is essentially what I argue in a paper I am working on: That efficient markets are a region in the parameter space of more general market models, and that by traversing that parameter space one can generate different market outcomes. By way of illustration, take the public signal out of the above cited paper [1]. Without the coordination provided by the public signal the law of iterated expectations works again for the average expectations operator!

Regarding the source of heterogeneity, I don't agree with your citation of irrationality or biases. I am not an expert on behavioral economics but from what I understand, behavioral models seem very fragile to the insertion or presence of even a few rational agents, hence the need to erect "limits of arbitrage" by adding frictions, constraints, etc. It is possible to motivate heterogeneous expectations in a more robust way, see my reference [3] above and further references therein, for example. The basic idea is to generalize the economic system from ergodicity or even stationarity, so that heterogeneity is motivated epistemologically, rather than psychologically.

[crabasa]

Comments like this make me wish that HN had a "follow" button.