‘The stock market’s movements are generally consistent with rational behaviour by investors. There is no need to invoke fads, animal spirits, or irrational exuberance to understand the movements of the market.’ Discuss in relation to the information technology bubble and its collapse.
Introduction
In a perfectly efficient market, it is assumed that all investors have access to all available information of future stock prices, dividend payoffs, inflation rates, interest rates and all other economic factors that affect the present prices of stocks. All investors are perfectly rational and choose to invest in stocks which will have a positive payoff. Therefore, all financial assets must always be priced correctly. Any apparent deviations from the correct pricing for stocks, according to the efficient market theory, must be an illusion, and no gains can be made from arbitrage. In short, all stock prices should reflect genuine and fundamental information about the value of the stock in question. There would be no need to explain changes in price by invoking fads, animal spirits and irrational exuberance.
By this theory, stock prices corrected for a time trend should follow a random walk through time, as any changes are only due to new information, which by definition cannot be predicted in previous periods.
Most empirical studies using data on a stock market to test whether stock prices follow a random walk has been statistically rejected. Also, from a non-specialist point of view, it is easy to find examples in history where stock prices seemed not to have followed a random walk, the dotcom boom of the late 90s being an often-quoted example.
The idea of an efficient market is very natural. From observation, it doesn’t seem easy to make lots of money by buying low and selling high, just as many investors fail on the stock market as succeed. If certain ‘smart’ investors can find ways to make profits on the stock market by buying low and selling high, then, according to theory, they will drive asset prices to their true values; by buying under-priced assets they will drive up those prices, by selling over-priced assets they will drive down those prices. Also, if there were substantial mispricing of assets, the ‘smart’ investors should make ...
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Irrational Exuberance and the Dotcom Bubble
It is almost impossible to distil the factors that contributed to the dotcom bubble. I think there at least some of the causes must originate from a rational framework, but I also think that they alone are not convincing enough; one has to invoke some irrational exuberance in order to explain the bullish stock market during the late 90s.
Psychological experience shows that there are patterns of behaviour in the stock market which cannot be contributed to ignorance, but which nevertheless cannot be classed as rational behaviour. People tend to use past prices as anchors for predicting present prices, so when certain shares are seen as valuable, people tend to regard them as increasing in value. This obviously creates a feedback loop, leading to the bubbles. Also, herd behaviour can dictate how an individual will react. People tend to follow their contemporaries, because we all find it difficult to doubt something in which many others believe. Again, this creates the feedback loop that can lead to speculative bubbles.
The stock market crash of 1929 is the primary event that led to the collapse of stability in the nation and ultimately paved the road to the Great Depression. The crash was a wide range of causes that varied throughout the prosperous times of the 1920’s. There were consumers buying on margin, too much faith in businesses and government, and most felt there were large expansions in the stock market. Because of all these...
It was previously assumed that economic investors and regulators (agents) utilised all available information and thus market prices were a reflection of this information with assets representing their fundamental value, encouraging the position that agents’ actions were rational. The 2007-2008 Global Financial Crisis (GFC) is posited to have originated from the notion that all available information was utilised, causing agents to fail to thoroughly investigate and confirm “the true values of publicly traded securities,” leading to a failure to register the presence of an asset price bubble preceding the GFC (Ball 2009).
It is often said that perception outweighs reality and that is often the view of the stock market. News that a certain stock may be on the rise can set off a buying spree, while a tip that one may be on decline might entice people to sell. The fact that no one really knows what is going to happen one way or the other is inconsequential. John Kenneth Galbraith uses the concept of speculation as a major theme in his book The Great Crash 1929. Galbraith’s portrayal of the market before the crash focuses largely on massive speculation of overvalued stocks which were inevitably going to topple and take the wealth of the shareholders down with it. After all, the prices could not continue to go up forever. Widespread speculation was no doubt a major player in the crash, but many other factors were in play as well. While the speculation argument has some merit, the reasons for the collapse and its lasting effects had many moving parts that cannot be explained so simply.
Before playing the stock market game, I honestly had no idea about how the stock market work. I, however, have learned so much about the process of the stock market. It was an advantage to learn how to buy and sell stocks without losing any thing, that will indeed enable me to invest in the real stock market without any concern. I learned that there is no certainty about wining or losing; however, there are many factors that we should consider before buying or selling stocks. One of theses factors is follow the daily news about the firm that you are willing to buy its stocks. Following the history of the firm transactions is also a significant factor that must be considered. The level of stability
The Stock Market Crash marked a major turning point in the history of the United States. For decades the U.S. was the world’s leading superpower, but after the crash the country cascaded into the worlds most harsh depression. This crash was caused by a series of problems in the U.S. including, the over production of goods, unequal distribution of wealth and poor regulation of the stock market itself. Many can argue that the crash of 1929, strengthened the nation, allowing for policies such as roosevelt's first new deal, second new deal, the glass steagall banking act, and new regulations in the stock market, and for big business (Blumenthal, Karen). However, what can’t be argued is how the crash sparked a panic as companies, peoples, and the nation sank into the great depression.
Technology, and the subsequent shift to program trading by computers, has been a major market shift. This has allowed trading volume to skyrocket. The Stock Market Crash of 1987, which saw the Dow plummet 507.99 points or, 22.61% on Oct. 19, 1987, was blamed on program trading that caused investors to rush for the exits in an extreme example of herd behavior. Currently, there has been speculation that flash traders, or investment shops that employ high frequency trading to buy and sell huge amounts of stocks, are creating unusually heavy market volatility (1).
There wasn’t just a single action or event that sparked the stock market crash. It was a series of bad judgements and choices made by the consumers, over looked by expenses and the era they had just experienced full of wealth and prosperity. Nobody saw this coming, or could even suspect this of happening. Consumers continuously invested in the stock market, leading to over speculation, poor government policies and and all around an unstable economy. Large investors catching wind of a bad outlook and future in the stock market, pulled their money out of the market and went straight to the banks. Because of the crash and its aftermath which revealed serious flaws in American economy, it led up to the Great Depression. The crash caused over 5,000 banks to close and for the many who invested their money only in banks, it was devastating crisis. Farmers started facing tough times when unemployment rates rose. Nobody had the money to pay for the food leaving farm prices dirt cheap, which meant lower income...
] This catastrophic event is caused by the accumulation of a large scale of speculation by not only investors but also banks and institutions in the stock market. Though the unemployment rate was climbing during the 1920s and economy was not looking good, people on Wall Street were not affected by the depressing news. The optimism spread from Wall Street to small investors and they were investing with the money they don’t have, which is investing on margin as high as 90%. When the speculative bubble burst, people lost everything including houses and pensions. The main reason ...
The stock market is a volatile, unforgiving battleground where fortunes can be made and lost within minutes. The first major stock exchange in the United States, The New York Stock Exchange (NYSE), dates back to 1792 when it acquired its first securities. Since then, the stock sarket has reached an astronomical size, with a market volume of over twenty trillion dollars. This success is not without its setbacks, though. The stock market crashes of 1929 and 2008 have single-handedly led to the worst economic recessions America has ever seen. Considering the sharp ramifications of a market crash, it is important to understand why
Efficient market hypothesis was developed by professor Eugene Fama at the University of Chicago Booth School Of Business as an academic concept of study through his published Ph.D. thesis in the early 1960s . Fama proposed two crucial concepts that have defined the conversation on efficient markets in his thesis. The efficient market hypothesis was the prominent theory in the 1960s, Fama published dissertation arguing for the random walk hypothesis to support his efficient market theory. “Fama demonstrated that the notion of market efficiency ...
The efficient market, as one of the pillars of neoclassical finance, asserts that financial markets are efficient on information. The efficient market hypothesis suggests that there is no trading system based on currently available information that could be expected to generate excess risk-adjusted returns consistently as this information is already reflected in current prices. However, EMH has been the most controversial subject of research in the fields of financial economics during the last 40 years. “Behavioural finance, however, is now seriously challenging this premise by arguing that people are clearly not rational” (Ross, (2002)). Behavioral finance uses facts from psychology and other human sciences in order to explain human investors’ behaviors.
Market efficiency signifies how “quickly and accurately” does relevant information have its effect on the asset prices. Depending upon the degree of efficiency of a market or a sector thereof, the return earned by an investor will vary from the normal return.
Chapter 11 closes our discussion with several insights into the efficient market theory. There have been many attempts to discredit the random walk theory, but none of the theories hold against empirical evidence. Any pattern that is noticed by investors will disappear as investors try to exploit it and the valuation methods of growth rate are far too difficult to predict. As we said before the random walk concludes that no patterns exist in the market, pricing is accurate and all information available is already incorporated into the stock price. Therefore the market is efficient. Even if errors do occur in short-run pricing, they will correct themselves in the long run. The random walk suggest that short-term prices cannot be predicted and to buy stocks for the long run. Malkiel concludes the best way to consistently be profitable is to buy and hold a broad based market index fund. As the market rises so will the investors returns since historically the market continues to rise as a whole.
In turn everything in the present and the future is judged through the stocks as they hold a high importance in industrialized economies showing the healthiness of said countries economy. As investing discourages consumer spending over all decreases, it lead...
The stock market is an essential part of a free-market economy, such as America’s. This is because it provides companies the capital they need in exchange for giving away small parts of ownership in their company to investors. The stock market works by letting different companies sell stocks to gain capital, meaning they sell shares of their company through an exchange system in order to make more money. Stocks represent a small amount of ownership in a company. The more stocks a person owns, the more ownership they have of that company. Stocks also represent shares in a company, which are equal parts in which the company’s capital is divided, entitling a shareholder to a portion of the company’s profits. Lastly, all of the buying and selling of stocks happens at an exchange. An exchange is a system or market in which stocks can be bought and sold within or between countries. All of these aspects together create the stock market.