Tonight's subject was 'price discovery' - what it means, how it works and how it can sometimes go wrong...and how this relates to the fascinating world of 'behavioral finance' and ultimately how our natural emotions can affect our decision making abilities.
Price discovery - What it means
The basics of supply and demand control the price in any 'free' market. If more people want something the price goes up, if less people want something the price comes down. This concept reveals itself in 'normal' market conditions as continually small increments around what is termed 'value'. When the stock markets are operating in this manner it's possible to benefit and to a certain extent 'control' these movements, simply by selling when an instrument is over-valued and buying when its under-valued. In trading terms the level at which the instrument is considered over-valued is termed 'resistance' and the level at which its considered 'under-valued' is termed 'support'.
Wild market swings can occur during 'normal' market conditions. This is an accepted fact. For example in 2007, Wheat doubled in price from $7 to $13 before quickly returning to around $7. Why this happened is explained below.
How it works
In normal market conditions, the 'value' price of an instrument has a relationship to it's fundamental price. The 'value' price for a bushel of wheat takes into account, the cost of production, storage and distribution - fundamental components, together with 'supply' and 'demand'. When this lot is thrown together, out pops a 'fair' value for a bushel of wheat. In early 2007, adverse weather conditions had severely impacted the supply of wheat. Crop reports began to hint at supply problems - (remember the film 'Trading Places' and the importance of the report on Orange Juice?). These supply problems quickly drove the price of wheat to record highs. At the same time, farmers, realising the additional margins to be had from Wheat, switched from growing soybeans and corn to growing wheat. As this additional supply filtered back into the market, so the price quickly reduced. The natural laws of a free market prevailed - BUT the swings were super-normal.
Fischer Black (an American economist) and one of the authors of the famous 'Black-Scholes' equation stated that Free Market theory means prices are usually somewhere between double and half of their fundamental value!
And how it can sometimes go wrong
Lets head back to sub-prime in the US....Banks stocks rose in the US because of the increasing amounts of mortgage backed securities that they were trading. As they lent more to mortgage companies, who in turn securitised more debts with the banks, so the stocks rose even more. Ascertaining what the fundamental (fair) price of a bank is, is hugely complex at the best of times, however as their loan books continued to explode, it became even harder. As the first signs of trouble began to filter through the US economy (increasing numbers of foreclosures), investors in banks, driven by their emotions (greed), continued to purchase bank stocks - and their stocks continued to rise. Banking stocks were now rising in a manner that was inconsistent with 'price discovery' and 'fair value'. As foreclosures increased, so banks themselves, began to doubt their valuations. Suddenly the emotion of the investor switched from greed to fear and banks valuations began to fall sharply. Again 'price discovery' and 'fair value' played no part in these huge falls.
What is evident here is that bubbles and crashes have little to do with fundamental valuations and ALL to do with the behaviours of those who participate in them.
Behavioral finance
Behavioural finance is a well known subject areas and has been studied by some of the greatest economists in modern times. And yet, we (the investor) continue to make the same mistakes! We trade on our emotions, we buy because we are greedy and we sell because we are fearful. Studies were done on professional traders during the tech bubble/bust in the early 2000's. It was noticed that during periods of profit, traders displayed higher levels of testosterone, which lead to increased risk-taking and more bravado. During the bust period, traders displayed higher levels of Cortisone, the body's natural way of dealing with stress, and a way of suppressing bad memories. Greed and Fear are natural emotions and removing them from your trading is extremely difficult.
The greatest traders however HAVE removed them from their trading. They can admit when they wrong and they can make rational and informed decisions irrespective of their emotion. They do not follow crowds, they do not listen to others, they have trading plans and they stick to them. These people are few and far between, but it is these people that will continue to profit in the markets in good times and in bad.
