| Just as it is important that networks for | | | | markets are efficient. |
| transport, electricity and telecommunications | | | | According to the efficient market hypothesis |
| function properly, so is it essential that, for | | | | (EMH), only changes in fundamental factors, such |
| example, payments can be transacted, capital can | | | | as profits or dividends, ought to affect share |
| be saved and channeled to the most profitable | | | | prices. |
| investment projects and that both households and | | | | (But this largely theoretic academic viewpoint also |
| firms get help in handling financial uncertainty and | | | | predicts that little or no trading should take |
| risk as well as possibilities of spreading | | | | place— contrary to fact— |
| consumption over time. Financial markets | | | | since prices are already at or near equilibrium, |
| constitute an important part of the total | | | | having priced in all public knowledge.) But the |
| infrastructure for every society that has passed | | | | efficient-market hypothesis is sorely tested by |
| the stage of largely domestic economies. | | | | such events as the stock market crash in 1987, |
| The financial system performs three main tasks: | | | | when the Dow Jones index plummeted 22.6 per |
| first, it handles transfer of payments; second, it | | | | cent— the largest-ever one-day fall in |
| channels savings to investments with a good | | | | the United States. (However, this was part of a |
| return for future consumption; and third, it | | | | world-wide crash of stock markets which did not |
| spreads and reduces (local enterprise) economic | | | | originate in the US.) This event demonstrated that |
| risks in relation to the players' targeted returns | | | | share prices can fall dramatically even though, to |
| (but note that systemic risk is not thereby | | | | this day, it is impossible to fix a definite cause: a |
| reduced— it merely becomes less | | | | thorough search failed to detect any specific or |
| concentrated and uneven). Moreover, unforeseen | | | | unexpected development that might account for |
| risks, or catastrophic risks (such as the complete | | | | the crash. It also seems to be the case more |
| collapse of the financial system or government | | | | generally that many price movements are not |
| institutions), may not be capable of being spread, | | | | occasioned by new information; a study of the |
| or insured against. | | | | fifty largest one-day share price movements in |
| The smooth functioning of all these activities | | | | the United States in the post-war period confirms |
| facilitates economic growth in that lower costs | | | | this.[2] Moreover, while the EMH predicts that all |
| and enterprise risks promote the production of | | | | price movement (in the absence of change in |
| goods and services as well as employment. In this | | | | fundamental information) is random (i.e., |
| way the financial system contributes to increased | | | | non-trending), many studies have shown a |
| prosperity. | | | | marked tendency for the stock market to trend |
| The stock market is one of the most important | | | | over time periods of weeks or longer. |
| sources for companies to raise money. | | | | Various explanations for large price movements |
| Experience has shown that the price of shares | | | | have been promulgated. For instance, some |
| and other assets is an important part of the | | | | research has shown that changes in estimated |
| dynamics of economic growth. Rising share prices, | | | | risk, and the use of certain strategies, such as |
| for instance, tend to be associated with increased | | | | stop-loss limits and Value at Risk limits, |
| business investment and vice versa. Share prices | | | | theoretically could cause financial markets to |
| also affect the wealth of households and their | | | | overreact. |
| consumption. Therefore, central banks tend to | | | | Other research has shown that psychological |
| keep an Argus eye on the control and behavior | | | | factors may result in exaggerated stock price |
| of the stock market and, in general, on the | | | | movements. |
| smooth operation of financial system functions. | | | | Psychological research has demonstrated that |
| Financial stability is the raison d'etre of central | | | | people are predisposed to 'seeing' patterns, and |
| banks. | | | | often will perceive a pattern in what is, in fact, |
| Relation of the stock market to the modern | | | | just noise. |
| financial system The financial system in most | | | | (Something like seeing familiar shapes in clouds or |
| western countries has undergone a remarkable | | | | ink blots.) In the present context this means that |
| transformation. One feature of this development | | | | a succession of good news items about a |
| is disintermediation. A portion of the funds | | | | company may lead investors to overreact |
| involved in saving and financing flows directly to | | | | positively (unjustifiably driving the price up). A |
| the financial markets instead of being routed via | | | | period of good returns also boosts the investor's |
| banks' traditional lending and deposit operations. | | | | self-confidence, reducing his (psychological) risk |
| The general public's heightened interest in investing | | | | threshold.[3] Another phenomenon— |
| in the stock market, either directly or through | | | | also from psychology— that works |
| mutual funds, has been an important component | | | | against an objective assessment is group thinking. |
| of this process. Statistics show that in recent | | | | As social animals, it is not easy to stick to an |
| decades shares have made up an increasingly | | | | opinion that differs markedly from that of a |
| large proportion of households' financial assets in | | | | majority of the group. An example with which |
| many countries. In the 1970s, in Sweden, deposit | | | | you may be familiar is the reluctance to enter a |
| accounts and other very liquid assets with little | | | | restaurant that is empty; people generally prefer |
| risk made up almost 60 per cent of households' | | | | to have their opinion validated by those of others |
| financial wealth, as against less than 20 per cent in | | | | in the group. |
| the 2000s. The major part of this adjustment in | | | | In one paper the authors draw an analogy with |
| financial portfolios has gone directly to shares but | | | | gambling.[4] In normal times the market behaves |
| a good deal now takes the form of various kinds | | | | like a game of roulette; the probabilities are |
| of institutional investment for groups of individuals, | | | | known and largely independent of the investment |
| e.g., pension funds, mutual funds, hedge funds, | | | | decisions of the different players. In times of |
| insurance investment of premiums, etc. The trend | | | | market stress, however, the game becomes |
| towards forms of saving with a higher risk has | | | | more like poker (herding behavior takes over). |
| been accentuated by new rules for most funds | | | | The players now must give heavy weight to the |
| and insurance, permitting a higher proportion of | | | | psychology of other investors and how they are |
| shares to bonds. | | | | likely to react psychologically. |
| Similar tendencies are to be found in other | | | | We are also liable to succumb to biased thinking. |
| industrialized countries. In all developed economic | | | | An example is when supporters of a national |
| systems, such as the European Union, the United | | | | football team (or a favorite stock), for instance, |
| States, Japan and other first world countries, the | | | | are overconfident about the chances of winning |
| trend has been the same: saving has moved | | | | (or the stock moving up). |
| away from traditional (government insured) bank | | | | The stock market, as any other business, is quite |
| deposits to more risky securities of one sort or | | | | unforgiving of amateurs. Inexperienced investors |
| another. | | | | rarely get the assistance and support they need. |
| The stock market, individual investors, and | | | | In the period running up to the recent Nasdaq |
| financial risk Riskier long-term saving requires that | | | | crash, less than 1 per cent of the analyst's |
| an individual possess the ability to manage the | | | | recommendations had been to sell (and even |
| associated increased risks. | | | | during the 2000 - 2002 crash, the average did not |
| Stock prices fluctuate widely, in marked contrast | | | | rise above 5%). The media amplified the general |
| to the stability of (government insured) bank | | | | euphoria, with reports of rapidly rising share prices |
| deposits or bonds. This is something that could | | | | and the notion that large sums of money could be |
| affect not only the individual investor or | | | | quickly earned in the so-called new economy |
| household, but also the economy on a large scale. | | | | stock market. (And later amplified the gloom |
| The following deals with some of the risks of the | | | | which descended during the 2000 - 2002 crash, so |
| financial sector in general and the stock market in | | | | that by summer of 2002, predictions of a DOW |
| particular. This is certainly more important now | | | | average below 5000 were quite common.) |
| that so many newcomers have entered the | | | | Irrational behavior Because a considerable part of |
| stock market, or have acquired other 'risky' | | | | the stock market is comprised of non-professional |
| investments (such as 'investment' property, i.e., | | | | investors, sometimes the market tends to react |
| real estate and collectables). | | | | irrationally to economic news, even if that news |
| With each passing year, the noise level in the | | | | has no real effect on the technical value of |
| stock market rises. Television commentators, | | | | securities itself. Therefore, the stock market can |
| financial writers, analysts, and market strategists | | | | be swayed tremendously in either direction by |
| are all overtalking each other to get investors' | | | | press releases, rumors and mass panic. |
| attention. At the same time, individual investors, | | | | Furthermore, the stock market is comprised of a |
| immersed in chat rooms and message boards, | | | | large amount of speculative analysts, or pencil |
| are exchanging questionable and often misleading | | | | pushers, whom have no substantial money or |
| tips. | | | | financial interest in the market, but make market |
| Yet, despite all this available information, investors | | | | predictions and suggestions regardless. Over the |
| find it increasingly difficult to profit. Stock prices | | | | short-term, stocks and other securities can be |
| skyrocket with little reason, then plummet just as | | | | battered or buoyed by any number of fast |
| quickly, and people who have turned to investing | | | | market-changing events, turning the stock market |
| for their children's education and their own | | | | in a generally dangerous and difficult to predict |
| retirement become frightened. Sometimes there | | | | environment for those people whose lack of |
| appears to be no rhyme or reason to the | | | | financial investment skills and time does not |
| market, only folly. | | | | permit reading the technical signs of the market. |
| This is a quote from the preface to a published | | | | Conclusion There have been innumerable |
| biography about the well-known and long term | | | | recommendations about how to make the stock |
| value oriented stock investor Warren Buffett.[1] | | | | market easier and safer for the casual, |
| Buffett began his career with only 100 U.S. | | | | non-professional investor. Few, if any, are likely to |
| dollars and has over the years built himself a | | | | prove useful or effective. However, in order to |
| multibillion-dollar fortune. | | | | minimize the risks of financial market imbalances, |
| The quote illustrates something of what has been | | | | it is important that there be a well thought-out |
| going on in the stock market during the end of | | | | legislative, regulatory, and supervisory |
| the 20th century and the beginning of the 21st. | | | | infrastructure that functions properly, smoothly, |
| The behavior of the stock market From | | | | and honestly. This is a never-ending task that |
| experience we know that investors may | | | | requires the participation of all concerned. |
| temporarily pull financial prices away from their | | | | Today, average individuals face sometimes very |
| long term trend level. | | | | difficult risk management decisions that were not |
| Over-reactions may occur— so that | | | | required of previous generations. Both |
| excessive optimism (euphoria) may drive prices | | | | opportunities and risks for the individual investor |
| unduly high or excessive pessimism may drive | | | | have been amplified many times over. Yet the |
| prices unduly low. | | | | average investor still lacks the relevant |
| New theoretical and empirical arguments have | | | | knowledge. Everyone cannot be a specialist in risk |
| been put forward against the notion that financial | | | | management and financial theory. |