Tuesday, 2 September 2008

Market Risk

Even if the earning power of the corporate sector and the interest rate structure remain more or less unchanged, prices of securities, equity shares in particular, tend to fluctuate.

While there can be several reasons for this fluctuation, a major cause appears to be the changing psychology of the investors.

There are periods when the investors become bullish and their investment horizons lengthen. Investor optimism, which may border on euphoria, during such periods drives share prices to great heights. The buoyancy created in the wake of this development is pervasive, affecting almost all the shares.

On the other hand, when a wave of pessimism (which often is an exaggerated response to some unfavourable political or economic development) sweeps the market, investors turn bearish and myopic. Prices of almost all equity shares regiter decline as fear and uncertainty pervade the market.

The market tends to move in cycles. As John Train says:

"You need to get deeply into your bones the sense that any market, and certainly the stock market, moves in cycles, so that you will infallibly get wonderful bargains every few years, and have a chance to sell again at ridiculously high prices a few years later."

The cycles are caused by mass psychology. As John Train explains:

"The ebb and flow of mass emotion is quite regular: Panic is followed by relief, and relief by optimism; then comes enthusiasm, then euphoria and rapture, then the bubble bursts, and public feeling slides off again into concern, desperation, and finally a new panic."

One would expect large scale participation of institutions to dampen the price fluctuations in the market. After all institutional investors have core professional expertise to do fundamental analysis and greater financial resources to act on fundamental analysis. However, nothing of ths kind has happened.

On the contrary, price fluctuations seem to have become wider after the arrival of institutional investors in larger numbers.

Why? Perhaps the institutions and their analysts have not displayed more prudence and rationality than the general investing public and have succumbed in equal measure to the temptation to speculate.

As John Maynard Keynes had argued, factors that contribute to the volatility of the market are not likely to diminish when expert professionals supposedly possessing better judgment and knowledge compete in the market place.

Why? According to Keynes, even these peope are concerned with speculation (the activity of forecasting the psychology of the market) and not enterprise (the activity of forecasting the prospective yield of assets over their whole life).

No comments: