All financial theory taught in any business school or textbook throughout the world operates on the assumption that markets are efficient creations full of rational investors, adeptly incorporating new information as it is released in the form of properly priced securities. The events of the last few days have clearly shown that this is not the case.
This is not to say that financial (and most economic) theories have no use in this world. Understanding the tenets of financial theory (risk is rewarded by return, the difference between non-systematic and systematic risk, the importance of diversification, and so on) teaches your mind to think in a certain manner, and lets you examine the world in a different and for many purposes better way. I would say that the same arguments that are used by people who go to law school just to "learn a different way to think" with no intent of practicing law can be applied to getting a background in Finance.
However, it has to be understood that these theories are just that, theories. While many do hold true to some degree or another, the reality of the human-factor of the markets should never be underestimated. Humans are not completely rational beings, limited to decision making based on logic and fact. Humans are highly emotional, oftentimes impulsive decision makers that can just as easily overreact to an new event in any part of the world as they could properly evaluate and integrate this information into their actions within markets, as financial theories would have us believe.
The Greek debt crisis serves as an excellent case study for the affect of the "human-factor" on markets. There are several reasons why Greece's inability to pay down their debt and the effect this has on the Euro can negatively affect the U.S. market overall. However, the Greek debt crisis should for no reason bring down every single company trading in the market. There are several publicly traded corporations whose future growth, earnings, and success has zero correlation to Greece or even the Eurozone. Look at the following chart comparing yields on Greek debt (the blue line) and the price of Apple stock (the green line) over the past month.
The blue line going up means the yields on Greek bonds are increasing- in layman's terms, it is costing Greece more and more to borrow money, because investors are losing confidence in their ability to pay it back. As the yield of Greek bonds increases, Apple shares decline.Taking into account all Apple related news over this one month period (you can take a look for yourself by pulling up Apple quotes for the past month on Google Finance), it can be said with fair certainty that Apple shares declined because of the Greek debt crisis' growth. Why?
Fear. Investor fear regarding the Greek crisis and the possibility of it spreading throughout Europe led investors to take part in massive sell offs, including with Apple shares. Looking at the fundamentals of Apple and where its expected growth and future success are supposed to come from in the next few years renders this sell off and the associated decline in the Apple share price as unreasonable. The success of the iPad in the United States alone, future income via the sale of books & magazines for the iPad, expected earnings from the supposed introduction of the iPhone to Verizon Wireless's 93 million subscribers, and the continued growth in market share of Apple products (the iPad, iPhones, iPods) in the United States, China, and so on (even pretending Greece suddenly stopped existing as a marketplace) warrant a higher share price. But, the emotional nature of investors nevertheless led to Apple shares falling.
What can one do in such a market? I believe the best strategy is still one of value investing. If you have picked good-value stocks with strong fundamentals, they will eventually rise despite overall market sentiments and emotions. As fearful emotion driven traders sell off shares and drive down their prices, contrarian investors who have properly evaluated and researched their trades will buy up the shares at the new "on-sale" price, eventually bringing stock prices back to where they belong.
This is not to say that financial (and most economic) theories have no use in this world. Understanding the tenets of financial theory (risk is rewarded by return, the difference between non-systematic and systematic risk, the importance of diversification, and so on) teaches your mind to think in a certain manner, and lets you examine the world in a different and for many purposes better way. I would say that the same arguments that are used by people who go to law school just to "learn a different way to think" with no intent of practicing law can be applied to getting a background in Finance.
The Greek debt crisis serves as an excellent case study for the affect of the "human-factor" on markets. There are several reasons why Greece's inability to pay down their debt and the effect this has on the Euro can negatively affect the U.S. market overall. However, the Greek debt crisis should for no reason bring down every single company trading in the market. There are several publicly traded corporations whose future growth, earnings, and success has zero correlation to Greece or even the Eurozone. Look at the following chart comparing yields on Greek debt (the blue line) and the price of Apple stock (the green line) over the past month.
The blue line going up means the yields on Greek bonds are increasing- in layman's terms, it is costing Greece more and more to borrow money, because investors are losing confidence in their ability to pay it back. As the yield of Greek bonds increases, Apple shares decline.Taking into account all Apple related news over this one month period (you can take a look for yourself by pulling up Apple quotes for the past month on Google Finance), it can be said with fair certainty that Apple shares declined because of the Greek debt crisis' growth. Why?
Fear. Investor fear regarding the Greek crisis and the possibility of it spreading throughout Europe led investors to take part in massive sell offs, including with Apple shares. Looking at the fundamentals of Apple and where its expected growth and future success are supposed to come from in the next few years renders this sell off and the associated decline in the Apple share price as unreasonable. The success of the iPad in the United States alone, future income via the sale of books & magazines for the iPad, expected earnings from the supposed introduction of the iPhone to Verizon Wireless's 93 million subscribers, and the continued growth in market share of Apple products (the iPad, iPhones, iPods) in the United States, China, and so on (even pretending Greece suddenly stopped existing as a marketplace) warrant a higher share price. But, the emotional nature of investors nevertheless led to Apple shares falling.
What can one do in such a market? I believe the best strategy is still one of value investing. If you have picked good-value stocks with strong fundamentals, they will eventually rise despite overall market sentiments and emotions. As fearful emotion driven traders sell off shares and drive down their prices, contrarian investors who have properly evaluated and researched their trades will buy up the shares at the new "on-sale" price, eventually bringing stock prices back to where they belong.
