Stock Market Speculation

A few weeks ago a colleague of mine was telling me how he had been watching this great company and was thinking of investing in it. All the pundits had said that the stock is on the up and it was a great deal – a “strong buy” they said, but he paused mid way though his sentence and said “why would anyone sell me their stock if they knew the price was going to rise?”

He had inadvertently stumbled upon the Efficient Market Hypothesis (EMH).   

The Competition

In the US 57 million households own shares out of 115 million, if we apply this logic the rest of the west there is a total of 139million people holding shares. Not all of these will be actively trading them; many will be sitting on the asset in the hope of selling it when it reaches a certain height, but a lot of them will be. The big money is controlled by hedge fund mangers, who can push and pull money around the world in an instant. They have the tools which provide them the latest information before anyone else (other non-traders), the minute a news story hits, millions of pounds are traded in an instant. They use every statistical and mathematical modelling there is to help them make the best purchasing decisions.

Often you will hear a friend say “invest in this company it’s under priced, you’ll make a fortune!” Before you do, ask them, “Do you think you have seen something that none of the 139 million traders haven’t?”

EMH

If an asset market, that has good level of liquidity (lots of buyers and sellers), the price is a perfect indicator of value. That is, the price reflects all information that is available. If the price was not truly reflective of the value of the stock, the millions of traders around the world would identify it and trade until the price did. 

Imagine a new piece of news hits the market that would cause a change in the value of the share. The price would respond almost immediately. By the time you read about it the paper the next day, the price is already fully reflective of that news story. If you were to buy the asset then, you are no longer going to gain from that particular news story. However you do have a 50:50 chance of gaining on the next story, before it comes out. This is the only way, according to the Efficient Market Hypothesis; you can beat the market and earn a short term return.

The price of an asset as an aggregate reflection of the combined wisdom of all the traders and analysts, with millions of traders speculating around the world, often disagreeing on strategy, no one trader can be expected to consistently gain over the others. When prices are not fair, they are randomly so, this means a trader will gain as much as they loose.

In short, when you think you can beat the market because you’ve heard a news story or just have a belief in a stock just remember “Trust markets, not people”. This also applies to the analyst in the papers that tell you to buy or sell a share; in this respect they are no different to an astrologist.

Animal Spirits

Like many economic theories, there is a slight problem with the EMH, humans are animals and are not entirely rational.

Humans suffer from all sorts of irrational behaviour, for example underestimating the odds of wining the lottery is common one. This irrationality also applies to the markets. Some traders hold a false belief that a stock is going to continue to rise due to cognitive biases (when holding a belief, the trader will search evidence that support that belief and ignore the evidence that does not).   

Prices can offer suffer mass distortions of value by traders not looking at the value of stock, but at what other people think the stock is worth. John Maynard Keynes (the equivalent of Jesus to economists) said “We have reached the third degree where we devote our intelligences to anticipating what the average opinion expects the average opinion to be.”

In a case of some bad news hitting the markets, traders are not looking at what the true value of a stock is, but what the average person is going to do with that stock. This creates herd type behaviour, where every shareholder runs for the exit in a mass panic with a ‘beggar thy neighbour’ mentality – Get out before anyone else does.    

Equally bubbles can form, where an assets price is massively overvalued. Because the average person believes the average person believes the stock is going to rise, it will do - in a self fulfilling prophecy.  A great example, I believe (although I suffer from cognitive biases as much as the next…) is gold. Gold historically was used for the basis of several currencies; in that respect it was an excellent store of value. Today however it is not the basis of any currency in the world. It’s only practical use is for jewellery and electrical products. However speculators believe that the average person believes that it is still a good store of value. As such, during the recent tough times, the price of gold has increased 160%. Buyers of gold believe they can sell it to a greater fool, and that greater fool believes he can sell to an even greater fool, and the bubble continues.

John Maynard Keynes lost a fortune, to what he called the ‘animal spirits’ in the markets. When a wheat was under valued he brought tonnes of it, assuning it would rise, however the rest of traders continued to sell, causing Keynes to left with tonnes of wheat that he was unable to sell .  

The list of irrational behaviours is a long one, and judging when markets will behave rational (EMH), and when it will not (animal spirits), is a difficult task.

 

If you’re thinking of investing in a stock, ask your self this – does the average opinion expect the average opinion to be rational?