Self-fulfilling expectations

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Stock markets have a very interesting and very important peculiarity. I’m talking about self-fulfilling expectations, that is the fact that if people expect something to happen, it happens for the simple fact that it was expected.

It’s very simple how this works: imagine, for example, that enough stock-owners expect stock prices to fall. In this case, they will try to sell their shares before prices fall too-much. But their selling, because of the basic law of supply and demand law”, will affect stock prices, lowering them. So you can see that just because people expected prices to fall, prices fall.

Clearly, the final effect will depend from how many people expected the price fall to happen: roughly, prices will diminish proportionally to how many people believed they would fall (I gave an example with price fall, but also for price rise it would work just the same way).

Self-fulfilling expectations  are important to keep in mind when you try to foresee stock market trends.
In my opinion the most relevant approach to the stock markets is fundamental analysis (as someone may have guessed since my definition of stock price), i.e. analysis of budget (and other) indexes and ratios, prospects for the business sector, etc.
But this isn’t the only tool people can use to analyze stock trends, and in fact it probably isn’t even the most used. The most used analysis tool is maybe graphical and technical analysis, which relies only on past market data (mainly prices and volumes). While technical analysis have some scientific (or, at least, logical) explanation of why something should happen, in my opinion it’s not completely satisfying in stock market forecasting (to quote Peter Lynch: “charts are great for predicting the past“). Obviously, it also depends on what you are looking for.

Nevertheless, I think it’s important for an investor to know very well technical analysis, because there is a lot of people that use it and so technical analysis may not predict stock prices, but  it will predict technical analysts behavior, that may be a very useful information.

In fact,  to successfully invest in the stock market is not enough to choose the analysis technique you like best and study in-depth just that. You need to know every technique (or at least, the most used), people use, since you may get some hint on some emerging expectation that (if enough people is involved) may self-fulfill itself.


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