Tag Archives: stock market

Behavioral Finance: Making Irrational Decisions

During my discussion of fundamental and technical analysis, I have held an underlying assumption that investors act rationally. A rational investor makes decisions in an effort to maximize their wealth depending on their level of risk tolerance. On the contrary, evidence suggests investor irrationality exists in the market. For example, investors that missed out on stock market gains are experiencing feelings of regret that might encourage them to make irrational decisions. According to the Wall Street Journal, “Some who got out of stocks five years ago are fixating on how much richer they would have been if they had stayed put”. Making investments based on security analysis is a way to avoid making irrational decisions based on emotions such as regret. However, some investors struggle ignoring strong emotions. When they consider how much more profits they would have earned if they had not sold their stocks then they experience a powerful source of regret.

The psychological impact that this can have on an investor might lead them into making irrational decisions. According to the Wall Street Journal, “Conversely, if you have missed out, you may chase the rising market in a desperate attempt to get back to ‘break-even,’ or the level of wealth you would have had if you had stayed in all along”. Investing with a chip on your shoulder (i.e. in pursuit of missed profits) can cause investors to make irrational decisions that they would not otherwise make.

Psychologist Daniel Kahneman is often considered the father of behavioral finance, which is a school of thought that attempts to explain such irrational decision-making. A Random Walk Down Wall Street by Burton Malkiel discusses Kahneman who won the Nobel Memorial Prize in Economic Sciences for his work on behavioral finance. According to Malkiel,

“Behavioralists believe that market prices are highly imprecise. Moreover, people deviate in systematic ways from rationality, and the irrational trades of investors tend to be correlated. Behavioral finance then takes that statement further by asserting that it is possible to quantify or classify such irrational behavior. Basically, there are four factors that create irrational market behavior: over-confidence, biased judgments, herd mentality, and loss aversion” (237).

In this case, I believe the factors causing irrational market behavior is loss aversion followed by herding. Investors that sold their stocks five years ago likely did so because of the dire economic outlook at that time. Due to strong feelings of loss aversion, investors sold some or all of their stocks. According to Malkiel, “Kahneman and Tversky’s most important contribution is called prospect theory, which describes individual behavior in the face of risky situations where there are prospects of gains and losses… losses are considered far more undesirable than equivalent gains are desirable”. Five years ago was 2009 and the economic outlook was extremely uncertain at best (if not, very negative). The prospect of losses due to the poor economic outlook likely encouraged some investors to sell some or all of their stocks.

As the U.S. stock market tripled since 2009, some investors that sold their stocks are experiencing regret over forgone profits. Having initially sold stocks due to loss aversion, these investors begin to regret their decision because of the stock market’s continuous surge upwards. According to Malkiel, “Groups of individuals will sometimes reinforce one another into believing that some incorrect point of view is, in fact, the correct one”. Herding, which has pushed stock prices up over the past five years, has also convinced investors that sold their stocks that they were wrong in their decision. Now those investors that sold stocks are considering purchasing stocks to join the herd in hopes of making back missed profits.

An investor experiencing regret can take a few steps to control this feeling and avoid making an irrational decision. According to the Wall Street Journal, “First, engage in what Eric Johnson, a psychologist and director of the Center for Decision Sciences at Columbia Business School, calls ‘therapeutic reframing’, or looking at the same evidence from a different angle”. For example, consider how much lower your performance would have been if you sold out of stocks entirely. However, this would not help those that sold out of stocks completely. Second, an investor that is decided on buying stocks again can do so in a smart manner. According to the Wall Street Journal, “And if you feel you absolutely must buy more stocks to catch up, do so gradually by tiptoeing in over the next year or two in equal monthly installments”.  I believe this is a good method for investing in general. As stock prices perform their random walk, spreading out your investment can spread out the price at which you purchase stocks and help avoid buying during peaks.

Stocks Don’t React to Crimea News

After the news about Crimea’s vote to leave Ukraine and join Russia, there was the possibility of seeing a reaction in the stock market. However, people are relieved to see that the U.S. stock market rose, despite potentially-problematic political tensions with Russia. It seems like for now, the situation is not severe enough to prompt a significant disruption in the market. A Wall Street Journal article explains that “the outcome matched market participants’ expectations… prompting investors to unwind cautious bets meant to protect against potential market-spooking headlines. Looking ahead, investors are awaiting details of any economic penalties to be imposed on Russia by Western leaders, who have said a Russian annexation of Crimea would be illegal.” This morning, the official sanctions were announced by President Obama: “sanctions on specific individuals responsible for undermining the sovereignty, territorial integrity and government of Ukraine…second, sanctions on Russian officials — entities operating in the arms sector in Russia and individuals who provide material support to senior officials of the Russian government.”

The sanctions are very limited, only concerning specific individuals tied to Putin’s government. So the stock market, in ignoring the Crimea news, is not likely to be affected by this announcement either. “U.S. stocks climbed, rebounding after last week’s selloff, as investors took Crimea’s widely expected vote to secede from Ukraine in stride.” The Dow Jones Industrial Average rose 192 points, or 1.2%, to 16259 in today’s trading. The S&P 500 rose 18 points, or 1%, to 1860. The Nasdaq Composite Index also rose 45 points, or 1.1%, to 4290.

And good indicators continue to pronounce themselves in favor of recovery. Federal Reserve data showed U.S. industrial production rose 0.6% in February (which was higher than expected). Capacity utilization increased to 78.8% (a slight, but important change). Alan Gayle, director of asset allocation at RidgeWorth Investments, says that the data supports the notion that U.S. economic growth is still on track, and a series of weak points around the start of the year were mostly about severe winter weather than a falter on economic recovery.

Thus, the good news today is two-fold: stocks rose despite the news from Crimea (which is a good sign persistent, stable recovery) and the recovery seems to be strong. At this point, growth is slow but steady – which may be exactly what the economy needs. If we saw excessively-fast growth and stimulus, we would be more concerned with inflation than the economic recovery. It is best to focus on this kind of current growth, which seems to be relatively stable.

Time to Sell on Chain Lunch Shops?

Within the past week two notable lunch time favorites have filed for bankruptcy, one of which filed for the second time in just three years. The more popular of the two is Quiznos, famously known for their oven toasted subs. The other is Sbarro, the chain pizzeria often found in food court type settings. Are these two bankruptcies a sign that its time to sell any holdings you have in lunch time shops or do they happen to be isolated incidences that happened to occur in the same week. Before it can be speculated upon it only makes sense to look at the recent history of the two lunch shops.

Quiznos has faced some probably in the past years with its competition. In my personal opinion the food holds its own when competing in its segment for lunch time sub shops, however the restaurant doesn’t have a special something that sets it apart from the others. Subway has its great deal with a $5 footlong and Jimmy Johns is “Freaky Fast”. Quiznos attempted for being the “mmm…toasty” place, however most places toast your subs anyway so this didn’t separate them much. Now they are filing bankruptcy so they have money to “further enhance the customer experience”

Sbarro seems to be in a bit of a different boat. They seem to be on the lower price range when it comes to the lunch market and their food isn’t prepared to order as seen in the many sub shops. The pizza is actually pre cooked and upon selection is heated up again before serving to the customer. Not the most appealing, however it seems you get what you pay for. The problem is the slices are not competitively priced against local food chains. If you go to a local pizzeria you can often get a fresher slice of pizza or a bigger slice for a better value. This makes the Sbarro sell a bit harder. Sbarro much like Quiznos lacks a separation factor that brings customers back.

After reviewing the recent history, I definitely wouldn’t urge one to go out an purge their portfolio of any popular lunch time restaurant for fear of soon bankruptcy. I would just caution investors to be diligent when reviewing companies, looking for that special something that can keep companies coming back, turning long run profits. And as for Quiznos and Sbarro, I don’t think this is the end of the line. If they turn to some brilliant marketers they may be able to scheme up a plan to entice new customers.

Some Claim Good Year for Stock-Picking

A recent WSJ article hailed the return of good performance for stock pickers.  The argument the article makes is that in recent years, stocks have mostly moved together for a variety of reasons, including strong signals from central banks.  The strength of how stocks move together, or their correlation can easily be measured.

Stock Correlation

As the graphic shows, during the recent recession, correlation between stocks was fairly high, but the correlation has trended lower in recent months.  Stock pickers argue that this is good for them, because when stocks are too strongly correlated it is hard for experts like themselves to differentiate themselves from a less advanced investor.  The article closes with an ironic statement from a stock-picking fund manager.  He states, “The sorting-out process has to return to fundamentals.”

The argument of stock-pickers makes a subtle but important observation:  Performance is relative.  Over spring break, a peer mentioned that his friend had given him a hot stock tip last year and made him some money.  I had to break it to him that his friend was no savant, but the entire market performed exceptionally last year. This story illustrates the point stock pickers make; since the whole market was moving up, it didn’t take skills to do well, or even get lucky.  Thus, doing well, compared to other investors, was difficult, because everyone did well.  This observation is accurate so we cannot, and should not judge how good a fund manager is based the nominals returns he/she brought in, but the returns relative to the market.  What does the evidence say about the performance of stock pickers, who are also known as “active” fund managers?

Unfortunately for stock-pickers this is where their confidence, some might call it arrogance, clashes with their results. The facts are simple:  “historically, active managers have tended to perform badly, even when dispersion was above average”.  Dispersion is another measure of how much stocks vary compared to one another, and has an inverse relationship to correlation. The very same feature of the market that stock-pickers were touting as beneficial for them has not helped them one bit!  The author of the article advocates for investing in passive funds or indexes to save on transaction costs.

Looking at the evidence, I will admit that my view lies somewhere in between these two articles, similar to those of Burton Mankiel. The overwhelming statistical evidence is very convincing that trying to pick the right stocks (or stock manager) is nearly impossible.  The silly arguments that active managers use while pointing at previous returns for their funds fall dead on the ears of managers who underperformed and are now looking for a job.  However, success investors can make a lot of money, Warren Buffet being an example.  As Burton Mankiel writes towards the end of his commentary on fundamental analysis in “Random Walk”, “if there are exceptional financial manager, they are very rare, and there is no way of telling in advance who they will be.”  Speaking of the 30+% rise in the S&P500 in 2013, Mr. Buffett “warned shareholders in his last annual letter he would be unlikely to beat [those returns]”.

I think an interesting line of investigation from here is determining why the general public entrusts so much money to active investors, when the results show that may not be the best investing strategy.  I suspect part of the reason is ignorance, that the general public doesn’t know what the statistics say or don’t understand the importance of relative gains.  Perhaps another reason is fear; the stock market has a reputation of being a tough place, and some people will turn to a professional out of fear.  Other reasons, like referrals, belief in stock -picking could also play a part in this trust, whether it is well founded or not.

Learning from the Bull Market

Many investors have suppressed the reality of the stock market crash of March 9, 2009. Now March 2014, five years after the crash, investors have been pouring their money back into stocks. $172 billion has been added to U.S. stock mutual funds and exchange-traded funds- more than had been withdrawn from 2008 to 2012 combined. Another $24 billion has been added in 2014.

According to this Wall Street Journal article, it has taken an average of 3.3 years for stocks to surpass their high set before the typical bear market began. “Unless you think the next bear market and subsequent recovery will be worse than average, sticking with stocks is the best response to the certainty that, sooner or later, the current bull market will come to an end”. This being said, it is necessary to look at the entire picture. After the 1929 stock market crash, the Dow didn’t surpass its 1929 pre crash peak until 1954- 25 years later. Therefore, the Dow paints a distorted picture of recovery. Firstly, it only represents 30 stocks (the stock must be a leading, widely held stock in its industry). Second, it doesn’t include dividends- this was a big portion of stocks’ total return in the 30s. Third, a big portion of declines in the Dow disappears after adjusting for deflation.

Even though the average has taken 3.3 years, it is understandable as an investor to be complacent. This WSJ article suggests that investors need to reflect on how a bear market affected their behavior in the past and factor that into how it should affect their thinking now. What is a bear market? WSJ defines it as when stocks fall 20% from a peak. A bull market is defined as when stocks rise 20% off a low point. In sum, this article cites stock market events that have happened in the past and suggests how these past actions may affect investors decisions in the future. Advice is suggested regarding being skeptical of experts, remembering what the recession felt like, limiting risk-taking, being wary of the labels “bull market” and “bear market”, and questioning performance figures.

To sum up these arguments, in terms of being skeptical of experts- pick the ones who seem aware of the uncertainty of their predictions and are willing to change their minds. An “expert” who once had a correct prediction won’t necessarily be right the next time around. In terms of remembering what the recession felt like- if an investor stayed put during the crisis, then he or she should stay put now. If an investor sold during the crisis, then this investor will almost certainly sell again if the market takes another steep fall. Limiting risk taking- investors are better off keeping a smaller amount in stocks and sticking with this allocation in good times and bad. Being wary of labels- as implied earlier, an average is not a very good measure of performance. It’s better just to look at whether or not stocks are valued more highly than in the past. Now, stocks are trading at about 25 times average earnings. The historical average is 16.5. Lastly, questioning performance figures- “Research by finance professor Raghavendra Rau of the University of Cambridge and his colleagues has shown that investors flock to funds whose five-year returns improve when a bad month drops out of the beginning of the sequence.” Fund companies often raise fees and take advantage of “improved” performance by dropping the month of February 2009 and starting at March 2009. Clearly, skipping this pivotal month makes returns seem much more appealing.

SEC considers the value of a nickel

High frequency trading (HFT) is a topic that many find difficult to understand.  The premium placed on speed of execution makes it seem a bit sketchy to the average investor despite research that says it actually decreases trading costs and adds liquidity to the market.  In order to bring back consumer trust, some think that trading should be slowed down, to roughly 20 times per second.  While it may make people think markets are fairer, it would take away some of the demonstrated benefits of such trading, like the increased liquidity and decreased cost of trading.  Instead of limiting trading to 20 times a second, in order to restore investor confidence while keeping the benefits, trading could be limited to tick sizes of .05, or one twentieth of a dollar.

As reported in the Wall Street Journal, the SEC is considering increasing the tick size from .01 to .05.  The change is to be tested on stocks with a market share under 750 million.  It is argued that this would make trading these smaller companies’ stocks easier.  While the program is for stocks with small market capitalizations, I believe that such a policy could be instituted on all stocks to curb the types of HFT that is not benefiting investors. In order to see how the tick size rule would affect this “bad” type of HFT, we first need to good trading from bad.  The good types of trades are trades that add the beneficial aspects, like market making and low latency trading. A market marker essentially takes either side of a deal in order to capture the “spread”, the difference between the bid and ask prices.  This provides liquidity.  The increased speed allows the traders to get the best prices in order to make a profit, and competition narrows the spread, decreasing cost for investors.  Low Latency trading is trading that tries to take advantage of a mis-pricing of similar assets in different markets.  This enforces the law of one price and adds efficiency and liquidity to markets.  Increasing the tic size has little to no affect on HFT algorithms like these since by increasing the tic size, they have made the spread even larger, benefiting the market makers.  Low latency trading is unaffected if all markets have the same tick size, since the relationship between the assets price would still hold.  HFT trading like this is beneficial to the market and could continue unchanged. What would be affected by changing the tic size is so called “predatory” trading.  To see this, we first need a concept called market resilience.

High-speed traders often rely on a feature called market resilience (or market depth) to make their profits.  Intuitively, a deep market is one that can fill a large order without a large change in price.  When an order is filled (and removed) from the limit order book, one replaces it quickly.  In this way the bid and ask prices move very little with large orders as there will be enough shares to fill it at that price eventually.

Trading ahead of mutual and index fund rebalancing is an example of HFT that is little suspect.  While technically legal, the high-speed traders use common knowledge (at least on Wall Street) and their speed advantage to profit.  At the end of the month, index and mutual funds rebalance their portfolios based on the current market weighting of the index. The funds, being very large, need a large amount of shares.  Executing an order for the amount of shares they need would cause a massive change in price against them.  Instead, the large orders are cut up and entered in over time so as to lesson their market impact and hide the transactions.

To profit, traders spam “feeler” limit orders to search out the pending transactions.  Upon finding them, they place orders at optimal places in the limit order book, which will inflate the price of the security as the fund executes its orders.  A resilient market will return to its normal level quickly after a large order, so the high-speed traders, if they are fast enough, can effectively buy back the asset they just sold for a cheaper price, pocketing the difference.  This trade, and similar algorithms, depends on a high level of market resilience.

Changing the tick size would absolutely decrease market resilience.  Market resiliency is defined as the size of an order needed to move the market by a given amount.  It is about a trade off between the quantity I can sell and the price I can sell it at.  If the increments are farther apart, the market will move more with big orders, as it can only move in 5-cent increments vs. the previous one-cent.  This decreased resilience would make such predatory trading more difficult. While the proposed change would most certainly decrease the resiliency of the market, was the market in 2000 really not deep or liquid enough?

The opposition’s argument that it will result in increased cost to investors is trivial. The investors would be put in an immediate loss that is the spread, and now it would be larger. However, they shouldn’t be too much worse off by getting a price a few cents higher, since they benefit from the larger steps up as well.  More over, if decreasing the increments when we went to decimals in 2001 didn’t make investors significantly better off, why would moving them back the other direction make them significantly worse off?

The federal government has thought about getting rid of the penny due to its inefficiency.  It costs far more then a penny to make a penny.  The SEC should do away with it as well.  While the decrease in market resilience may be considered a bad thing, the United States went until 2001 with a wider gap (1/16th, as opposed to the proposed 1/20th), and the economy, as well as traders’ profits, where fine.  Moving to a tick size of 5 cents could be a step that increases investor confidence in the markets as well as in regulators to do their job in the quickly changing landscape of modern finance.

Now the time to invest?

After an historical year for the stock market in 2013, the market has been pretty flat to start off 2014. Yet, many smaller investors have started to get back into stock trading early this year. Is now the right time to be entering into the game, though? It may or may not be, and I will examine the possibilities of both sides of this question. Let’s hope for the sake of investors and the country as a whole that the answer is yes. There are certainly reasons to believe that the market will be fine, and I believe that although there is some risk in entering the trading game right now, in general it is a fine time to do so.

First of all, let’s take a look at the reasoning not to start putting your money into stocks at the moment. The main reason is simply the timing of how the market has been doing. “The risk is that investors are barreling into stocks at the tail end of a historic rally. In January, the S&P 500 declined 3.6%, the largest one-month drop since May 2012. It has risen 171% since its March 2009 low. The index has gained 3% in February.” As I briefly mentioned, the market had an incredible year in 2013, so to start investing when the market as a whole may well have already reached its peak is definitely a scary thought. The last thing you want to do is buy now and then have to sell later on when stock prices have fallen. Buying high and selling low is never a good idea. This is just what many small investors have experienced over the past seven years. However, I’m not so convinced that the market has reached its peak just yet. And apparently, many others are not completely convinced either. “At E*Trade, daily trades were up 27% from a year earlier. At TD Ameritrade and Schwab, the increases were 28% and 17%, respectively.

A bright spot to start off the year is the success that 2013 initial public offerings have had thus far in 2014. Overall, companies that went public last year are up 2.3% median year-to-date, which clearly tops the -0.7% that the S&P 500 has seen thus far this year and the -2.9% that the Dow Jones has experienced over the same time period. Some companies like Kindred Biosciences Inc. and BioAmber are even up 92% and 86% year-to-date, respectively. Obviously, it is not every company that has numbers like this, but it is certainly a good sign when at least some do. And while investing in IPOs is not always the safest bet, it can certainly pay off. Maybe some of the investors getting back into the swing of things will look toward IPOs this year as they are currently beating the market indexes thus far.

My final thought is that while the market did historically well last year, and has started off relatively flat this year, who is to say that it can’t make another run similar to the one it made in 2013? Or at least continue to do somewhat well. January was obviously tough on investors, but so far in February the market has fought back to almost pull even for the year. As with any time you choose to invest, pick your stocks wisely and everything should be alright. While I wouldn’t be one to put all of my money into stocks right now, I don’t think it would hurt to invest some of it, even at a time like this.

College Grads Financial Disaster

With a presumably large portion of this class expecting to graduate college in the near future, one common worry is our financial success after we walk down the isle and pick up our diplomas. Graduating for many marks the first time they will be out on their own, either entering the workforce or moving on with their schooling taking out substantial loans to pay for the continuance of their studies. Just like all other new beginnings, this one will be scary at first.

On top of being financially independent for the first time, there are many other complicating factors. Our economy is finally recovering from a recession and the job market looks optimistic for many. However we are all at an age where we understand what just happened. Seeing the market dive in 2009 has left many of us skeptical of investing money in stocks. A study found that most millennials are investing like their grandparents losing significant gains. Buying into an exchange-traded funded following the S&P 500 would have realized a 30% return, while many millennials money sat on money in savings accounts realizing very limited returns. After a shaky January the account would be down 4%, still having a sizable advantage over the out dated savings fund.

Aside from the market being a big scare, we also face the new age of electronic money. Something not many our age are afraid of and most of us embrace, however when not used properly it is easy to find ourselves in a financial disaster. If the class is anything like me, cash is becoming a scarcity in my wallet with most purchases being funded through debit or credit cards. As college graduates, its not likely were going to make a big ticket purchase right off the bat and bankrupt us for the future, however it is easy to lose sight of the every day purchases. The purchases add up over the month and it don’t have to be faced until it is summed at the end of the month in our bills. It’s likely that electronic currencies such as bitcoin will only further complicate this making it even more difficult to track our spending.

As scary as the first portion of this may seem, all hope isn’t lost for us. By acting responsible with our finances we can set ourselves up for long term success. The first recommendation for college grads is to get educated on personal finances and the stock market. I’d say our class has a solid leg up on our piers, however it is important that we remain informed about the status of the economy post graduation. The second piece of advice is to to work with a financial advisor and set  goals for yourself, both long term and short term. Weather its paying off grad school loans, owning your first home, paying for a big wedding, or retiring to a home on the beach in Florida, you just need something to work towards. Working towards your goals will not only help you eliminate impulse spending but also be rewarding when you finally reach them.

 

Although we will be up on the stock market, saving for things like retirement can be tricky. When we graduate it may seem to early to start saving, but if you have the extra money the investment could pay dividends in the long wrong. The problem is we most likely be as informed on the retirement type funds as some seasoned financial advisors. They will be able to explain the differences between 401(k)s, IRAs, Roth IRAs, and emergency savings funds. There is no perfect combination to use, each individual can use a unique combination to maximize their investment. Financial advisors can also help decide the benefits between things like professionally managed mutual and funds following a set index.

My last piece of advice is to have faith in the stock market. We’ve seen the troubles its caused in the recent years which scares us, but remember there were booming times too that we are too young to remember, and these times will return.

Stock Market Optimism

Despite recent perceptions of negative stock market conditions, The Dow Jones Industrial Average rose 7.71 points, which reversed a loss of as much as 60 points from Monday to record its third consecutive gain. The S&P 500 rose 2.82 points and the Nasdaq rose 22.31 points. Given the recent signs of slowing economic growth, it looks as though investors feel comfortable with stocks at current levels.

Managing director at Rosenblatt Securities, Gordon Charlop, commented that this was probably the best case scenario that we could have hoped for because the market didn’t break down. Many investors expect more volatility in 2014 after December’s less-than-ideal performance, especially after the pullback in Fed stimulus. However, many other investors still expect stocks to end higher on the year as long as corporate profits show strength. According to Thomson Reuters Corporation, about 68% of companies have reported fourth-quarter earnings that beat market expectations. This means that the market should continue in the same direction as long as earnings come in as they’re expected.

So far, earnings have been good, but there are also investors concerned about profit outlooks that companies have provided. As the US markets have currently experienced an overall gain, other quarters have ended lower such as industrials and energy stocks. Investors’ doubts root back to the current conditions in emerging markets. Given that earnings in emerging markets are unstable, this poses as a risk to multinational companies because they are trying to grow in emerging markets. Looking forward to the future, investors are anticipating Janet Yellen’s testimony to congress on Tuesday and Wednesday. However, most people do not feel that she will hold off on taper because they are not worried about surprises.

Last week I wrote about the effect of emerging markets in the US stock market. Now, it seems as though stock market expectations are much more optimistic. Even though Ms. Yellen’s testimony is Tuesday and Wednesday, some investors feel comfortable taking bullish positions. For example, “Joel Johnson, founder of Johnson Brunetti Retirement & Investment Specialists, said the market could remain volatile over coming weeks amid uncertainty over the economy and Federal Reserve policy, but he recommends investors not to overreact to short-term market weakness.” He is currently recommending his clients to expect pullbacks, remain on the same course, and they shouldn’t see what they saw last year. He advised that they should expect little a little volatility, but overall, markets should finish modestly higher and the economy should be in a better spot.

To Invest or Not to Invest…

Volatility has returned to the stock market. According to the Wall Street Journal, “The Dow Jones Industrial Average has swung up or down at least 100 points during the day on 25 out of the 26 trading days so far this year”. I believe the return of volatility is also a return of normalcy. I welcome it as it provides buying opportunities. During 2013, financial markets rallied virtually without interruption. Recently, markets have declined in what seems to be a correction. As I watch financial markets decline, I become excited about opportunities to purchase stocks cheap. Although I do not consider myself risk loving, I understand that risk and reward are intertwined.

However, not all people feel this way. According to the Wall Street Journal, “The financial industry has traditionally sorted investors into three types: conservative (willing to tolerate very little risk of loss), moderate (willing to take some risk) and aggressive (prepared to withstand high risk)”. For example, I think that conservative investors would certainly become frightened by  recent volatility. I find it hard to classify myself within these three categories. As a result, I prefer Benjamin Graham’s system in which investors are categorized as either enterprising or defensive. On the one hand, an enterprising investor is willing to spend time selecting securities that look more attractive than others. On the other hand, a defensive investor wants to avoid loss and does not want to make frequent decisions. Although the majority of the time I consider myself an enterprising investor, I become a defensive investor during school when I have less time to select securities.

Despite the weak performance in financial markets so far this year, stocks are still not cheap. According to the Wall Street Journal, “At the end of last year, U.S. equities were trading at 25 times their average earnings over the past decade, adjusted for inflation. At the recent low on Feb. 3, that was down to 24.2 – still far above the long-term average of 16.5, according to data from Yale University economist Robert Shiller”. On the basis of price to average earnings over the past decade, stocks continue to be expensive. I think this is a much more useful financial metric than forward price to earnings, which uses projected earnings that I find completely unreliable.

As an enterprising investor (at this moment I do have time to devote to security analysis), I hope that stocks continue to fall because this will provide more securities at bargain prices. According to the Wall Street Journal, “If you are an enterprising investor, then you should monitor the financial markets carefully in the hope that a substantial fall will present bargains”. This continues to be my attitude. Although I hope stocks continue to fall, cheap securities can still be found in the current market of mildly overpriced stocks (you just need to look hard!). As a result, some might call our current situation a stock pickers’ market. Whereas last year, a rising tide lifted all boats and one could have just invested in a stock market index.

I really value the integrity of financial markets, however, I become discouraged when I read about certain investors having a competitive advantage. According to the Wall Street Journal, “By paying for direct feeds from the distributors and using high-speed algorithms to crunch data and enter orders, traders can get a fleeting – but lucrative – edge over other investors… The reason: tiny lags between the time the distributors release the news and when media outlets send them out to the public, including other investors”. Although this direct access is not illegal, it destroys what is supposed to be an efficient market. The efficient market hypothesis suggests that financial markets reflect all publicly available information, however, for a few milliseconds traders paying for direct access have information that others do not. As someone investing for long-term gains, high-speed traders with direct access to news releases do not significantly impact my strategy. Nonetheless, I am surprised that this is type of activity is legal as it reminds me of insider trading.

Financial regulation seems to be way behind the curve. According to the Wall Street Journal, “The Securities and Exchange Commission’s fair-disclosure rule, Regulation FD, requires that public companies issue material information about their businesses to the broader public at the same time it is disclosed to market professionals… The rule, written before the era of high-speed trading, doesn’t address whether fractions of a second matter in terms of when information is distributed”. Based on this interpretation, it seems that the SEC intends for this type of trading to be illegal (obviously I am just speculating since it is hard to accurately determine the intentions of the SEC or any organization). I am curious about potential future regulation.