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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