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What is the Financial Market and how it can be to your advantage?

What is the Financial Market

If you happen to go to an open market, you’ll observe stalls where people are selling and buying goods. In this marketplace, prices of goods constantly change. Prices fluctuate depending on two factors; how much the product being sold is seasonal and therefore determines the quantity supplied and, on the quantity demanded by the consumer.

The concept of the financial market works very similar. It brings buyers and sellers together to trade in financial assets, such as bonds, shares, commodities, currencies, etc. Practically, it is used for setting up prices for global trade and for companies and governments to raise capital or to borrow money. It is also a means of transferring capital and risk from one hand to the other.

Markets can be unpredictable, and many find their movements very difficult to understand why they occur. According to Benjamin Graham, who was the teacher of the world’s greatest investor – Warren Buffett, describes the market as a gigantic auction arena where assets are valued every minute. To help us understand better the market movements, he introduced to us the analogy of ‘Mr. Market’, a fictitious character he describes, where every day he quotes to us prices of businesses. Sometimes he is in a bad mood and his price quotes are ridiculously cheap, sometimes he’s overoptimistic and his quotes are overpriced. So, his mood can go from very pessimistic to widely optimistic. Ben Graham’s advice is that we are free to ignore his offers if we are not convinced with his price quotes since he will soon come back with an entirely different offer.

The reality is that markets can be easily influenced by the media, economists, politicians and who’s their voice has an authority. Therefore, opinions and predictions of political and economic nature are the forces that move markets all the time, and the reaction is that news is priced-in quite instantly. This means that the markets move up or down in value equally to how people perceive the news will affect their investment. However, when the news doesn’t provide the positive or negative effect as previously perceived, market values correct themselves to more realistic levels, meaning they are very close to the current state of the business or country concerned. Ben Graham describes this market behaviour as; “In the short term the market is a voting machine but in the long them it is a weighing machine” In my opinion, there are people that with their voices or actions want to influence the market for a reason. For example, recent issues about Brexit, trade wars between US and China and the rising populism around the world are few of the issues that are making news today and eventually creating market volatility. However, depending if you are already invested and want to get out or preparing to chunk your money in the market, when market volatility occurs, some may anticipate a loss, but others can see it as an opportunity where money can be made.

Market volatility in itself is a way of gauging the current people’s sentiment reflected in their action, leading to prices changing constantly while ownership change hands. This mostly happen in markets which are highly liquid, meaning that a lot of trading occur. Conversely, if a market is illiquid, which means that not so much trading is taking place, the tendencies are that values don’t change. However, a word of caution here is that it doesn’t mean that risks are inexistent. In this situation, if a business is going through difficult times, its bond or share value quoted on the market may not be reflecting the true underlying situation of the company. In this scenario, one might encounter difficulties to sell the holding in time, particularly if the holding is a large number of nominal shares or bonds and the market for it is small. Similarly applies to other illiquid assets, such as property, which is an attractive asset today to invest in due to its anticipated return on investment. However, too much of your capital tied up in property carry risks. There could be times when the investor requires cash that due to slow economic times it won’t be easy to sell such property. As long the volatility risk is not related to a default of a company we have invested in or it’s not a speculative investment, where the share price has been hyped up, one doesn’t have to be preoccupied much.

Eventually markets will adjust the prices according to what the underlying financial performance of that company we are invested in. In his wise words Warren Buffett tells us; “To be fearful when others are greedy and greedy when others are fearful”. This means when we are most keen to buy, we should be most cautious, and when most are unwilling to buy it’s the moment we should be most aggressive in our purchases. This is called a ‘contrarian approach’ where one has to be disciplined and sometimes take decisions the opposite others are taking.

With this approach towards the market, opportunities to invest are created, where it goes to basics of investing. It works by looking particularly for company shares as if buying businesses. We all agree that their worth depends on what is capable of producing overtime. Many so-called ‘buy-and-hold’ investors seek for undervalued companies by using several evaluation techniques to determine the company present value. For example, by calculating the business future cash flows (what is capable of producing), then they discount the estimate value back with a percentage rate of return they are expecting for the risk they’re going to take to invest in that company.  Then, they use market fluctuations for their own advantage and seek a point to enter the market. Those companies, which are not much followed by market analysts have shown to be significantly underpriced in their respective share value and, when they have positive surprises, such as good news, they are subject to sharp upward price reevaluations.

Another way how to benefit from market fluctuations is by taking a ‘trader’ approach. The concept is to look at historic price movements of a share through various historic price patterns and follow a trend, which is commonly called ‘technical analysis’.Simply put, a trader doesn’t care which company name of the share is trading. What is important is that the choice of shares have price volatility, where buying occur as indicators show that the price is set to rise after a decline and sell as there are signs of the price is about to fall and take the margin profit. Normally, a trader does not hold the share for too long. In many occasions the holding only last for a few hours. That is why they are called ‘day traders’. This approach towards the market, is to jump from one shareholding to the other. Especially, if you anticipate that a shareholding won’t lead you to a successful trade of making a profit, then instantly pull out by selling and move to another share where you anticipate there is a trend that will lead you not only to make profit but to recuperate what you’ve just lost in the last trade. That is why you hear the saying; ‘Cut your losses and move on’

The unpredictability of market movements is another issue. Occasionally one can beat the market but, in my view, it’s very difficult to be above it all the time. A known fact is that the market can either reward or punish you for a decision you have taken or about to take, or a guilt feeling that you missed an opportunity of not being invested. It could be the case where one is making money whereas others are losing. Remember, that our emotional behaviour determine our actions. A known fact in psychology is that we are not wired to fail, especially when it comes to money. We feel they are too precious to lose, so we may take instant decisions that are not necessary the right ones.

In simple words, panics do occur in the market and one have to be careful not to be dragged with its negative sentiment. Selling your holding at times when market declines may result in losing money on your investment that might take time recuperate. The same when everyone is overoptimistic. All investments might look attractive to buy while it may not be the case.

A word of caution is that everyone can easily fall prey to the fear and greed that the market can offer. Even the smartest people the world. Sir Isaac Newton once said when describing the market; “I can calculate the motions of the heavenly bodies, but not the madness of the people.” No matter how brilliant he was, he also lost £20,000 after he couldn’t resist seeing others making huge profits on the market. He was caught up in the ‘South Sea Bubble’ market crash in the year 1720.

People’s attitude towards the market can go from one extreme to the other, from overconfidence (Bull market) to extremely cautious (Bear market). This what causes the huge swings we experience from time to time. In good times, people don’t see much that could go wrong because they perceive things are doing fine. So, they see risk as their friend, the more risk they take, the more money they think they can make. Then, when bad times come, they switch the opposite and panic start to kick in. They don’t care if they ever want to earn another cent in the market. With the fear of losing more money, they just want to sell everything they invested and get out of the market as fast as possible.

In a nutshell, these swings in people’s attitudes and behavior combine to make the financial markets what they are. However, as we’ve seen earlier, you can be smart enough by being determined to stick to a plan, be it a short or a long term one, you can let the market work to your advantage, and the reward can be exchanged in decent profits.

The Calamatta Cuschieri Traders Blog is available daily on CC WebTrader. Other market coverage including coverage of the International Bond Markets is also available.

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