Exciting New Research in Finance

Time to review the latest cutting-edge academic research, as discussed in our country’s leading business newspaper. A report in the Wall Street Journal from Monday brings us two items that expand our understanding of that mysterious beast known as the stock market.

NYSE-floor The first item is a recently released report from the Investment Company Institute (the trade group for mutual fund companies) which revealed that the average mutual fund investor’s willingness to take risk is lower now than it was two years ago before the market experienced its well publicized unpleasantness.

It is a report that is just chock full of enlightening insights. A person only needs to skim the chart captions to learn a lot. Turns out, “Tax-Deferred Accounts Are A Popular Way to Hold Mutual Funds.” And “Fund Performance Is the Most Important Factor Shaping Opinions of the Fund Industry.” Further, “Mutual Fund Industry Favorability Rises and Falls with Stock Market Performance.”

But it is more than just investor’s opinions of mutual funds that is affected by stock market performance. According to the other study mentioned in the WSJ, this one from a professor in the Personal Financial Planning department of the University of Missouri, the lower risk tolerance we have seen since ‘08 is not a fluke. From the press release:

… During the past two decades, the risk tolerance of investors is positively correlated to the movements of the stock market, meaning that investors are likely to invest more when market returns are high, and withdraw partially or even completely from the market when returns are negative.

[Professor] Yao warns that this tendency will ultimately lead to ineffective investment tactics and unnecessary financial losses. She says that a positive correlation between risk tolerance and stock market returns shows that investors are buying stocks at a high price and selling them at a low price, which is not sound investment strategy.

“To maximize returns, the ideal strategy is to buy stocks at a low price, with the hope of selling them at a higher price,” Yao said. “However, many investors seem to be unwilling to take risks when the market is at a low point and seem content to only invest when the market is at a high point.”

This has revolutionary implications for our understanding of stock market dynamics. If it is true, then what you might see after sudden price changes is a period of optimism or pessimism that would exaggerate, or at least not counteract, those price changes. For example, if the market went down a lot one day you might not see the immediate bounce back that would make sense, given prices that are suddenly a bargain. It might be that people would get all skittish and stay on the sidelines or even sell some more, causing prices to fall further.

Conversely, if the market goes up, that might make some investors increase their optimism, meaning that they would actually start to buy more at the new (higher) prices. And that could make those high prices go even higher. You might even see prolonged periods of pessimism and optimism driving market movements.

This is pretty scary stuff. Of course, more research needs to be done, but this does raise the chilling possibility that the stock market is not entirely driven by wholesome principles of economics. It might also be based on such things as investor psychology and sentiment. Instead of the rational machine for accurately valuing assets that we all think it is, the stock market might actually be a sloppy and chaotic mechanism that at best only tends toward true long-term value. It is almost too frightening to consider.

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