Wednesday, June 6, 2007

What triggers a downfall in the market?

AS a result of China's higher-than-expected economic growth of 11.1% and fear of possible further interest rate hikes in China, regional markets, including Malaysia, fell sharply last Thursday.

This was the second time after Chinese New Year (CNY) that a drop in Chinese stock prices rattled the markets across Asia.

According to Lee In Ho in his study on Market Crashes and Informational Avalanches, there are four stages in a market crash. They are boom, euphoria, trigger and panic.

Under the boom stage, the market will normally have a main theme that excites everyone about stocks.

In Malaysia, several positive measures under the Ninth Ma- laysia Plan got investors excited about the construction and property sectors. At this stage, this is seldom a bubble as companies continue showing good corporate results. A bubble will be created at the euphoria stage. The unjustified extrapolation of future earnings and the revision of higher target prices by research analysts can cause overconfidence in companies’ future performance.

A bubble will start to take shape when the general public reacts to this overconfidence. An irrational exuberance will occur when market prices and expectations about future values are far beyond the fundamentals of the companies.

However, no one will know when the rise will stop. A market will resume its upward trend until something triggers the downfall.

Usually, the stock prices get higher and steeper just before the market crash.

At the trigger stage, private information will reach a threshold that triggers other traders to alter their behaviour. At this critical situation, when almost everyone is at irrational exuberance, any event can trigger the market to tumble.

In January 1994, our stock market put the blame on former finance minister Tun Daim Zainuddin for saying that he had sold all his shares because prices had reached dangerous levels.

Until now, nobody can really understand the main reason behind the sharp plunge on the Shanghai Index right after the CNY.

According to some fund managers in China, the selling was mainly due to investors panicking when they noticed that their friends were selling stocks.

A famous researcher in behavioural finance, Robert Shiller, conducted a survey by asking institutional and individual investors what was in their mind during the stock market crash in 1987. One conclusion he drew was that the crash was due to people reacting to each other with heightened attention and emotion.

Investors seemed to follow what other investors were doing. As a result of action and reaction, a feedback loop was created when everyone had a simultaneous reaction to common stimuli.

A market crash is described as a process that corrects a public belief that is inconsistent with the current distribution of private information. The severity of a crash will depend on whether the market is filled by “new generation” investors or experienced traders.

“New generation” investors do not know anything about the stock market but are greedy and want to get quick money from it. A market will not crash if it has experienced traders who know how to control risk and when to cut losses.

However, if a market is filled by “new generation” investors with no holding power and do not know when is the right time to sell a stock, any sharp drop in prices could result in panic selling. At this panic stage, the fear of further drops could cause big fall in prices.

When will the stock market crash again?

My usual answer for this question is the stock market will not crash as long as you continue to worry about when it will crash. The market will crash at the time when you least expect it to happen. Investors should remember that the market always performs beyond your expectations.

We should not be too worried about when the market will crash. Instead, we should consistently review our portfolio and sell those stocks whose prices have gone beyond their intrinsic value

Source: TheStar

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Tuesday, June 5, 2007

Why some gain and others lose?

Morgan Kelly in his research (1997) entitled, Do Noise Traders Influence Stock Prices?, identified three types of investors: smart-money traders, noise traders and passive traders.

Smart-money traders always behave rationally whereas noise traders always buy high and sell low. Passive traders do not actively participate in the market most of the time.

According to Kelly, the probability of being a noise trader declines with income. As a result of higher income, smart-money traders can acquire more reliable research reports to help them in investment decisions.

Noise traders, being in the lower income group as well as lacking critical information and having wrong information, end up losing money in the stock market most of the time. Their aim to recoup losses lead to more losses. Nevertheless, the presence of this group of traders makes it possible for smart-money traders to make money.

In general, noise traders are always affected by emotion and past experience. They rush to sell when prices fall and buy when prices go up because they believe the current trend will continue into the future.

As a result of over-confidence and lack of self-control, they are unable to act rationally. Furthermore, due to a lack of financial training and limited capacity to process information, they tend to misinterpret economic and market information.
Most of the time they put faith in the information they want to hear and if that contradicts what they have done, they will “bend'' the information to confirm their actions.

Some noise traders rely on heuristics and rules of thumb to make decisions.
Heuristic refers to the process whereby investors develop their investment rules by trial and error. These will later develop into their own rules of thumb.

An example of the rule of thumb is buying stocks when the market transacted volume falls to 100 million a day and selling when the market volume surges beyond one billion a day. However, this rule of thumb has changed of late.

With the implementation of one board lot of 100 shares, we notice that the lowest daily market volume is about 400 million to 500 million. A daily market volume of one billion shares may not imply a sell signal. Given that there is no empirical evidence to verify the effectiveness of these heuristics, noise traders tend to commit systematic forecasting errors.

Apart from the above, noise traders also like to follow others in making investment decisions. This situation is called information cascading where investors make their decisions based on the observations of others’ previous actions. They will try to gather information available from the history of previous action choices.

For example, we choose restaurants that are full of customers than otherwise, without knowing how the food tastes.

Most day traders select stocks showing higher gains and bigger market volume. They may not know the exact reason for the strong buying interest in the stocks but they believe certain people may have certain private information.

However, when the private information on these stocks is not consistent with the value of the stocks, this can cause a heavy sell-down. The sudden reversal of an information cascade is called information avalanche.

Hence, noise trading keeps us from knowing the expected return on a stock.
Smart-money traders always maintain unbiased expectations and make rational decisions. Due to the inaction of passive investors, this may help to slow the decline of a stock.

Investors need to constantly upgrade their investment skills by reading up on stock market investment or attending courses on investment.

·Ooi Kok Hwa is a licensed investment adviser and managing partner of MRR Consulting.

Source: TheStar

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