Tuesday, November 6, 2007

Relation of the stock market to the modern financial system

The financial system in most western countries has undergone a remarkable transformation. One feature of

this development is disintermediation. A portion of the funds involved in saving and financing flows

directly to the financial markets instead of being routed via banks' traditional lending and deposit

operations. The general public's heightened interest in investing in the stock market, either directly

or through mutual funds, has been an important component of this process. Statistics show that in recent

decades shares have made up an increasingly large proportion of households' financial assets in many

countries. In the 1970s, in Sweden, deposit accounts and other very liquid assets with little risk made

up almost 60 per cent of households' financial wealth, compared to less than 20 per cent in the 2000s.

The major part of this adjustment in financial portfolios has gone directly to shares but a good deal

now takes the form of various kinds of institutional investment for groups of individuals, e.g., pension

funds, mutual funds, hedge funds, insurance investment of premiums, etc. The trend towards forms of

saving with a higher risk has been accentuated by new rules for most funds and insurance, permitting a

higher proportion of shares to bonds. Similar tendencies are to be found in other industrialized

countries. In all developed economic systems, such as the European Union, the United States, Japan and

other developed nations, the trend has been the same: saving has moved away from traditional (government

insured) bank deposits to more risky securities of one sort or another.

The stock market, individual investors, and financial risk

Riskier long-term saving requires that an individual possess the ability to manage the associated

increased risks. Stock prices fluctuate widely, in marked contrast to the stability of (government

insured) bank deposits or bonds. This is something that could affect not only the individual investor or

household, but also the economy on a large scale. The following deals with some of the risks of the

financial sector in general and the stock market in particular. This is certainly more important now

that so many newcomers have entered the stock market, or have acquired other 'risky' investments (such

as 'investment' property, i.e., real estate and collectables).

With each passing year, the noise level in the stock market rises. Television commentators,

financial writers, analysts, and market strategists are all overtalking each other to get investors'

attention. At the same time, individual investors, immersed in chat rooms and message boards, are

exchanging questionable and often misleading tips. Yet, despite all this available information,

investors find it increasingly difficult to profit. Stock prices skyrocket with little reason, then

plummet just as quickly, and people who have turned to investing for their children's education and

their own retirement become frightened. Sometimes there appears to be no rhyme or reason to the market,

only folly.

This is a quote from the preface to a published biography about the well-known and long term value

oriented stock investor Warren Buffett.[1] Buffett began his career with only 100 U.S. dollars and has

over the years built himself a multibillion-dollar fortune. The quote illustrates some of what has been

happening in the stock market during the end of the 20th century and the beginning of the 21st.

The behavior of the stock market
NASDAQ in Times Square, New York City.
NASDAQ in Times Square, New York City.

From experience we know that investors may temporarily pull financial prices away from their long term

trend level. Over-reactions may occur— so that excessive optimism (euphoria) may drive prices unduly

high or excessive pessimism may drive prices unduly low. New theoretical and empirical arguments have

been put forward against the notion that financial markets are efficient.

According to the efficient market hypothesis (EMH), only changes in fundamental factors, such as profits

or dividends, ought to affect share prices. (But this largely theoretic academic viewpoint also predicts

that little or no trading should take place— contrary to fact— since prices are already at or near

equilibrium, having priced in all public knowledge.) But the efficient-market hypothesis is sorely

tested by such events as the stock market crash in 1987, when the Dow Jones index plummeted 22.6 percent

— the largest-ever one-day fall in the United States. This event demonstrated that share prices can fall

dramatically even though, to this day, it is impossible to fix a definite cause: a thorough search

failed to detect any specific or unexpected development that might account for the crash. It also seems

to be the case more generally that many price movements are not occasioned by new information; a study

of the fifty largest one-day share price movements in the United States in the post-war period confirms

this.[2] Moreover, while the EMH predicts that all price movement (in the absence of change in

fundamental information) is random (i.e., non-trending), many studies have shown a marked tendency for

the stock market to trend over time periods of weeks or longer.

Various explanations for large price movements have been promulgated. For instance, some research has

shown that changes in estimated risk, and the use of certain strategies, such as stop-loss limits and

Value at Risk limits, theoretically could cause financial markets to overreact.

Other research has shown that psychological factors may result in exaggerated stock price movements.

Psychological research has demonstrated that people are predisposed to 'seeing' patterns, and often will

perceive a pattern in what is, in fact, just noise. (Something like seeing familiar shapes in clouds or

ink blots.) In the present context this means that a succession of good news items about a company may

lead investors to overreact positively (unjustifiably driving the price up). A period of good returns

also boosts the investor's self-confidence, reducing his (psychological) risk threshold.[3]

Another phenomenon— also from psychology— that works against an objective assessment is group thinking.

As social animals, it is not easy to stick to an opinion that differs markedly from that of a majority

of the group. An example with which one may be familiar is the reluctance to enter a restaurant that is

empty; people generally prefer to have their opinion validated by those of others in the group.

In one paper the authors draw an analogy with gambling.[4] In normal times the market behaves like a

game of roulette; the probabilities are known and largely independent of the investment decisions of the

different players. In times of market stress, however, the game becomes more like poker (herding

behavior takes over). The players now must give heavy weight to the psychology of other investors and

how they are likely to react psychologically.

The stock market, as any other business, is quite unforgiving of amateurs. Inexperienced investors

rarely get the assistance and support they need. In the period running up to the recent Nasdaq crash,

less than 1 per cent of the analyst's recommendations had been to sell (and even during the 2000 - 2002

crash, the average did not rise above 5%). The media amplified the general euphoria, with reports of

rapidly rising share prices and the notion that large sums of money could be quickly earned in the so-

called new economy stock market. (And later amplified the gloom which descended during the 2000 - 2002

crash, so that by summer of 2002, predictions of a DOW average below 5000 were quite common.)

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