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