September 28, 2007

Is the stock market based on facts or perception?


Question?: Why are stock markets so influenced by social factors like politics, etc.? It would seem that the financial markets are based more on perception than facts.

Answer: You’re right. It does seem as if the stock market is influenced by perceptual distortions. In fact, this is so prevalent that it has resulted in a body of knowledge known as “Behavioral Finance”, which explores how human irrationality can cause movements in stock prices.{{more}} One good example of this is something referred to as the optimistic bias. This theory says that individuals tend to form optimistic opinions about a share’s price and then find it very difficult to change that. Even if news comes out that tends to conflict with their opinion, they tend to underplay it or pay little attention to it. However, if news comes out which is consistent with their opinion, they tend to react strongly to it and become even more optimistic. This irrational optimism is one of the causes of the bull markets during the 1990s where no matter what information came out about the markets it would be interpreted as good news.

On the other hand, the fact that the market reacts to political factors may not be irrational, as politics does have an inextricable link to the performance of the economy, and hence the stock market. For example, one party’s tax policy may be different from another. Depending on which one is in power, the effect on businesses and the stock market can, therefore, be markedly different.

Question?: What does “Net Asset Value” mean when referring to shares?

Answer: The term net asset value is used when referring to the value of shares in a mutual fund. It is defined as the market value of the assets of the fund divided by the number of shares issued by that fund. For example, if a mutual fund has assets worth EC$1,000,000 and they are issuing 100,000 shares in the fund then the net asset value is $10/share. The net asset value of the shares in a mutual fund can go up or down depending on the movement in the market value of the assets in the fund. For example, if the value of the assets in the fund goes down to EC$900,000 due to a down market, then the net asset value would be $9/share ($900,000/100,000). Similarly, if the value of the assets in the fund increases to EC$1,100,000 then the net asset value would be $11/share ($1,100,000/100,000). If a fund has liabilities, which are used in the purchase of assets, this would have to be deducted from the market value of the assets in finding the market value of the fund. For example, if the value of a fund is EC$1,000,000 and EC$200,000 in loans were used to purchase assets, then the net value of the fund would be EC$800,000. The net asset value would, therefore, be $8/share ($800,000/100,000)

Question?: From the advice given in your columns, it seems that the sooner we understand how money works, the easier it is to feel financially secure. What are the most important things I can tell my children (aged 9 and 13) about money to give them a good start?

Answer: These are the most important things to tell your kids:

1. Develop a savings ethic

2. Always draw up a budget, periodically, which would guide your expenditure

3. Always keep an emergency fund for unforeseen expenses

4. Keep informed about ways and means to invest your funds

5. Make sure that you are getting the best rate of return for your money for a given level of risk

6. Start saving early and benefit from the power of compounding

Once you can engender these principles into your kids from an early age, it would serve them in good stead in managing money for the rest of their lives. You are right.

The sooner they are aware of these principles, the better. It is probably best that all children be required to take at least a rudimentary schooling in the basics of money management. However, in most schools, kids who go into the “science stream” are not exposed to this at all. Such courses should probably be mandatory just as Mathematics and English are.

All information contained in this article has been obtained from sources that CMMB believes to be accurate and reliable. All opinions and estimates constitute the Author’s judgment as of the date of the article; however, neither its accuracy and completeness nor the opinions based thereon are guaranteed. As such, no warranty, express or implied, as to the accuracy, timeliness or completeness of this article is given or made by CMMB in any form whatsoever.

CMMB and/or it employees or directors may, where applicable, make markets and effect transactions, or have positions in securities or companies mentioned herein. Neither the information nor any opinion expressed shall be construed to be, or constitute an offer or a solicitation to buy or sell.