Financial Market

Financial Market

When using some of the formulas, it is important to remember that the amount of stocks held can be negative: this situation is called shorting stocks. Basically, shorting a stock is trading in borrowed shares and is profitable when the price of a stock goes down. To illustrate, if person A believes that stock X will go down in the near future, A can borrow shares X from person B, sell them at current market price, buy the same number of stocks once price goes down, and profit by the difference.

The theory of efficient markets elucidates why it would be unwise to even try to beat the market. A random walk postulates that if there was a drunk man near a lamppost and every one of his steps were random, it would be impossible to predict where he would end up after 15 minutes and the best guess would be at the lamppost, since that is rationally the only place that has any link. Of course that is an imperfect analogy, but markets are unpredictable because of unforecastable information noise. In the hypothetical alternative, if the drunk had an elastic band attached to an ankle, the randomness would change because he would be pulled back, that is the autoregressive rationale. In the random walk (efficient market model) it is impossible to profit from trading due to the unpredictability of stock price behavior, whereas in the autoregressive model it is less so.

If price earnings ratio is low (usual around U.S. $15), prices are likely to go down, theoretically, and in no way sufficient motive to act on; dividends are fundamental since the only other way to make money on stocks is if price went up, but why would it rise if dividends were not paid. Companies that are just starting often do not pay dividends.

Toronto Dominion Tower. some of the most beautiful buildings in Toronto there are the city’s banks.  I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years (Warren Buffet). Illustration: Megan Jorgensen (Elena)

Since human behavior is rarely perfectly quantifiable and even less exactly mathematically predictable, behavioral finance comes in. The markets are in fact influenced by many aspects of other social sciences than economics, mainly political science, sociology and last but not least psychology.

Kahneman & Tversky (1979) developed a paradigm in their famous article on behavioral economics, proposing the prospect theory, in which expected utility is replaced with a value function. Utility is the economic measure of how happy an outcome makes an individual.

The utility function has an upward slope that gets less and less steep with every additional outcome; this process is called diminishing marginal utility. The suggested aspect is discontinuity in the slope of the value function, explained by the characteristic valuing of losses much more than gains. Hence, at times, losses dominate decision-making, as in sunk costs, when person is less likely to give up something in which much has been invested, even when continuing with the doomed undertaking seems irrational and counterproductive.

Reference:

    Kahneman, D. & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47(2): 263-92.