Thursday, November 25, 2010

The Stock Market

When people refer to "the stock market" or "the market" it can sometimes be confusing to beginning investors as to what those terms actually mean. Are they talking about all the stocks that trade on the NYSE, all the stocks that trade in the U.S., or all the stocks in the world? Typically when people refer to "the market" they are talking about all the publicly traded stocks in this country (they will usually say "the global market" if they mean the entire world). Indeed, the concept of "the market" can be a difficult one at first, especially since beginners tend to think of stocks as individual units. This section explains some different ways that investing experts think about the market as a whole.

Efficient Market

Proponents of the efficient market theory believe that there is perfect information in the stock market. This means that whatever information is available about a stock to one investor is available to all investors (except, of course, insiders, but insider trading is illegal). Since everyone has the same information about a stock, the price of a stock should reflect the knowledge and expectations of all investors. The bottom line is that you should not be able to "beat the market" since there is no way for you to know something about a stock that isn't already reflected in the stock's price. That's not to say that efficient market theory fans claim that all stocks are necessarily priced correctly; instead, they claim that there is no way for you to know whether or not prices are too high or too low. Proponents of this theory spend little time trying to pick stocks that are going to be "winners"; instead, they simply try to match the market's performance. However, there is ample evidence to dispute the basic claims of this theory, and most investors don't believe it.

Random Walk

The random walk theory draws conclusions that are similar to the efficient market theory, but it uses a different line of reasoning. The theory takes its name from a well-known book by Burton Malkiel (although others pioneered the idea decades earlier) which says that future stock prices are completely independent of past stock prices. In other words, the path that a stock's price follows is a "random walk" that cannot be determined from historical price information, especially in the short term. Much like efficient market theory fans, the random walkers believe that it is impossible to pick "winning" stocks and that your best bet is just to try to match the market's performance, usually by using a long-term buy and hold strategy.

Behavioral Finance

Behavioral finance theory is very different from the random walk and the efficient market theories. Proponents of behavioral finance believe that there are important psychological and behavioral variables involved in investing in the stock market that provide opportunities for smart investors to profit. For example, when a certain stock or sector becomes "hot" and prices increase substantially without a change in the company's fundamentals, behavioral finance theorists would attribute this to mass psychology (also known as the "follow the herd instinct"). They therefore might short the stock in the long term, knowing that eventually the psychological bubble will burst and they will profit.

Bull and Bear Markets

In addition to the three market theories mentioned above, there are other ways of thinking about the market as a whole, that are less theoretical and more grounded in what is actually happening to them. One way is to describe the overall trends in the market, such as by defining them as bearish or bullish. A bull market, loosely defined, is a market in which the major stock indexes have risen by over 20% over a substantial period of time, usually measured in months or years. Bull markets can happen as a result of an economic recovery, an economic boom, or simple investor psychology. The longest and most famous of all bull markets is the one that began in the early 1990s in which the U.S. equity markets grew at their fastest pace ever.

Bear markets are the exact opposite of bull markets: they are markets in which the major indexes have declined by 20% or more over a period of at least two months (a decline that large for any shorter time period is simply called a "correction", especially if it followed a substantial rise). Bear markets usually occur when the economy is in a recession and unemployment is high, or when inflation is rising quickly. The most famous bear market in U.S. history was, of course, the Great Depression of the 1930s.

Seasonal and Time-Related Market Factors

During certain times of the year or certain times of the month, the markets tend to exhibit certain behaviors more often than would be predicted by chance. For example, the early fall, October in particular, has historically been a time when the markets have slumped, although the effect isn't extremely pronounced and there isn't a logical explanation for it. Strong stock performance in January is another example of a seasonal market trend. The so-called "January Effect" occurs because many investors choose to sell some of their stock right before the end of the year in order to claim a capital loss for tax purposes. Once the tax calendar rolls over to a new year on January 1st these same investors quickly reinvest their money in the market, causing stock prices to rise. But although the January effect has been observed numerous times throughout history, it is difficult for investors to profit from it since the market as a whole expects it to happen and therefore adjusts its prices accordingly

Copied from Investor Guide.


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