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Riskier long-term saving requires that an individual possess the ability to manage the associated increased risks. Stock prices fluctuate widely, in marked contrast to the stability of (government insured) bank deposits or bonds. This is something that could affect not only the individual investor or household, but also the economy on a large scale. The following deals with some of the risks of the financial sector in general and the stock market in particular. This is certainly more important now that so many newcomers have entered the stock market, or have acquired other 'risky' investments (such as 'investment' property, i.e., real estate and collectables).

With each passing year, the noise level in the stock market rises. Television commentators, financial writers, analysts, and market strategists are all overtalking each other to get investors' attention. At the same time, individual investors, immersed in chat rooms and message boards, are exchanging questionable and often misleading tips. Yet, despite all this available information, investors find it increasingly difficult to profit. Stock prices skyrocket with little reason, then plummet just as quickly, and people who have turned to investing for their children's education and their own retirement become frightened. Sometimes there appears to be no rhyme or reason to the market, only folly.

This is a quote from the preface to a published biography about the well-known and long term value oriented stock investor Warren Buffett. Buffett began his career with only 100 U.S. dollars and has over the years built himself a multibillion-dollar fortune. The quote illustrates some of what has been happening in the stock market during the end of the 20th century and the beginning of the 21st.

Facts affecting Stock Prices

From experience we know that investors may temporarily pull financial prices away from their long term trend level. Over-reactions may occur— so that excessive optimism (euphoria) may drive prices unduly high or excessive pessimism may drive prices unduly low. New theoretical and empirical arguments have been put forward against the notion that financial markets are efficient.

According to the efficient market hypothesis (EMH), only changes in fundamental factors, such as profits or dividends, ought to affect share prices. (But this largely theoretic academic viewpoint also predicts that little or no trading should take place— contrary to fact— since prices are already at or near equilibrium, having priced in all public knowledge.) But the efficient-market hypothesis is sorely tested by such events as the stock market crash in 1987, when the Dow Jones index plummeted 22.6 percent — the largest-ever one-day fall in the United States. This event demonstrated that share prices can fall dramatically even though, to this day, it is impossible to fix a definite cause: a thorough search failed to detect any specific or unexpected development that might account for the crash. It also seems to be the case more generally that many price movements are not occasioned by new information; a study of the fifty largest one-day share price movements in the United States in the post-war period confirms this. Moreover, while the EMH predicts that all price movement (in the absence of change in fundamental information) is random (i.e., non-trending), many studies have shown a marked tendency for the stock market to trend over time periods of weeks or longer.

Various explanations for large price movements have been promulgated. For instance, some research has shown that changes in estimated risk, and the use of certain strategies, such as stop-loss limits and Value at Risk limits, theoretically could cause financial markets to overreact.

Other research has shown that psychological factors may result in exaggerated stock price movements. Psychological research has demonstrated that people are predisposed to 'seeing' patterns, and often will perceive a pattern in what is, in fact, just noise. (Something like seeing familiar shapes in clouds or ink blots.) In the present context this means that a succession of good news items about a company may lead investors to overreact positively (unjustifiably driving the price up). A period of good returns also boosts the investor's self-confidence, reducing his (psychological) risk threshold.

Another phenomenon— also from psychology— that works against an objective assessment is group thinking. As social animals, it is not easy to stick to an opinion that differs markedly from that of a majority of the group. An example with which one may be familiar is the reluctance to enter a restaurant that is empty; people generally prefer to have their opinion validated by those of others in the group.

In one paper the authors draw an analogy with gambling. In normal times the market behaves like a game of roulette; the probabilities are known and largely independent of the investment decisions of the different players. In times of market stress, however, the game becomes more like poker (herding behavior takes over). The players now must give heavy weight to the psychology of other investors and how they are likely to react psychologically.

The stock market, as any other business, is quite unforgiving of amateurs. Inexperienced investors rarely get the assistance and support they need. In the period running up to the recent NASDAQ crash, less than 1 per cent of the analyst's recommendations had been to sell (and even during the 2000 - 2002 crash, the average did not rise above 5%). The media amplified the general euphoria, with reports of rapidly rising share prices and the notion that large sums of money could be quickly earned in the so-called new economy stock market. (And later amplified the gloom which descended during the 2000 - 2002 crash, so that by summer of 2002, predictions of a DOW average below 5000 were quite common.)

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  • INTRADAY CHART
    DOW
    NASDAQ
    S&P
    NAME LAST CHANGE % CHANGE
    DOW 16,982.59 +22.02 +0.13%
    NASDAQ 4,444.91 -4.65 -0.10%
    S&P 1,978.91 unch unch
    10-Yr Note 100.23 +0.19 +0.19%
    • Market index data delayed by 15 minutes.
    VIDEO ON MSN MONEY
    MARKET UPDATE
    [BRIEFING.COM] S&P futures vs fair value: +2.50. Nasdaq futures vs fair value: +6.20. U.S. equity futures hover near their pre-market highs amid upbeat action overseas. Participants have received another batch of quarterly earnings since yesterday's closing bell with the likes of BP (BP 49.78, -0.86), Pfizer (PFE 30.26, +0.16), Merck (MRK 58.59, +0.62), and UPS (UPS 99.90, -2.76) in focus. The S&P 500 futures trade almost three points above fair value. Reviewing overnight developments: Asian markets posted gains. China's Shanghai Composite +0.2%, Japan's Nikkei +0.6%, and Hong Kong's Hang Seng +0.9% In economic data: Japan's Retail Sales fell 0.6% year-over-year (expected -0.5%, previous -0. ... More
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    ADVANCERS & DECLINERS
    NAME NASDAQ NYSE
    Advancers 983.00 1,329.00
    Declines 1,686.00 1,766.00
    Unchanged 103.00 130.00
    Advancers to Decliners 0.58 0.75
    Advancing Vol 679.73 Mil 1.15 Bil
    Declining Vol 1.07 Bil 1.60 Bil
    Unchanged Vol 20.78 Mil 53.53 Mil
    Total Vol 1.77 Bil 2.80 Bil
    TRENDS
    GAINERS
    SYMBOL NAME VOL LAST CHANGE % CHANGE
    LOCO El Pollo Loco Holdings Inc 26.9 Mil 34.48 +10.45 +43.49%
    FDO FAMILY DOLLAR STORES INC 35.44 Mil 75.74 +15.08 +24.86%
    TRLA TRULIA Inc 15.68 Mil 65.04 +8.69 +15.42%
    ATHM AUTOHOME Inc 494,949 37.30 +2.80 +8.12%
    GRUB GRUBHUB Inc 817,395 38.02 +2.79 +7.92%
    WUBA 58.COM INC 1.74 Mil 54.04 +3.81 +7.59%
    KEP KOREA ELECTRIC POWER CORP 267,256 19.92 +1.32 +7.10%
    VNET 21VIANET GROUP Inc 894,808 28.96 +1.74 +6.39%
    YZC YANZHOU COAL MINING COMPANY LIMITED 312,553 8.57 +0.51 +6.33%
    ACH ALUM CORP OF CHINA LIMITED 318,357 11.84 +0.68 +6.09%
    LOSERS
    SYMBOL NAME VOL LAST CHANGE % CHANGE
    AWI ARMSTRONG WORLD Inc 8.31 Mil 49.60 -5.77 -10.42%
    BMA BANCO MACRO S.A. 531,571 38.08 -3.80 -9.07%
    CWEI CLAYTON WILLIAMS ENERGY INC 168,594 115.87 -10.42 -8.25%
    CMP COMPASS MINERALS INTERNATIONAL Inc 1.63 Mil 87.43 -7.19 -7.60%
    XON INTREXON CORP 390,527 22.71 -1.49 -6.16%
    MKTO MARKETO INC 742,792 26.61 -1.62 -5.74%
    RARE ULTRAGENYX PHARMACEUTICAL Inc 133,776 40.67 -2.44 -5.66%
    LTM LIFE TIME FITNESS Inc 1.51 Mil 38.81 -2.21 -5.39%
    RAD RITE AID CORPORATION 84.93 Mil 6.69 -0.36 -5.11%
    CMCM CHEETAH MOBILE Inc 901,337 19.61 -1.02 -4.94%
    MOST ACTIVE
    SYMBOL NAME VOL LAST CHANGE % CHANGE
    RAD RITE AID CORPORATION 84.93 Mil 6.69 -0.36 -5.11%
    SIRI SIRIUS XM HOLDINGS INC 68.91 Mil 3.38 -0.06 -1.74%
    AAPL APPLE Inc 55.32 Mil 99.02 +1.35 +1.38%
    FB FACEBOOK Inc CLASS A 41.73 Mil 74.92 -0.27 -0.36%
    BAC BANK OF AMERICA Corp 39.32 Mil 15.50 -0.09 -0.58%
    DLTR DOLLAR TREE Inc 36.32 Mil 54.87 +0.65 +1.20%
    FDO FAMILY DOLLAR STORES INC 35.44 Mil 75.74 +15.08 +24.86%
    MU MICRON TECHNOLOGY Inc 34.2 Mil 31.98 -1.44 -4.31%
    GE GENERAL ELECTRIC 32.98 Mil 25.59 -0.20 -0.78%
    AMD ADVANCED MICRO DEVICES 31.45 Mil 3.73 -0.03 -0.80%
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    WORLD MARKETS
    NAME LAST CHANGE % CHANGE
    Nikkei 225 15,618.07 +88.67 +0.57%
    FTSE 100 6,826.49 +38.42 +0.57%
    DAX 9,670.20 +72.03 +0.75%
    TSX 15,445.22 -9.82 -0.06%
    COMMODITIES
    NAME LAST CHANGE % CHANGE
    Gold 1,307.20 +3.90 +0.30%
    Silver 20.66 +0.09 +0.45%
    Light Sweet Crude Oil 100.85 -0.82 -0.81%
    CURRENCIES
    SYMBOL RATE CHANGE % CHANGE
    EUR/USD 1.34232 -0.00139 -0.10%
    USD/JPY 102.05000 +0.22400 +0.22%
    GBP/USD 1.69444 -0.00376 -0.22%
    USD/CAD 1.08190 +0.00197 +0.18%
    USD/CNY 6.18050 +0.00300 +0.05%
    TREASURYS
    NAME LAST CHANGE % CHANGE
    3-Mo Bill 0.02 0.00 -10.00%
    5-Yr Note 99.64 +0.44 +0.44%
    10-Yr Note 100.23 +0.19 +0.19%


     
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