Theory of reflexivity and the Stock Market By Dr. Bobby Srinivasan and Dr. Sudhakar Balachandran

October 23, 2015 | Posted by bobbysrinivasan << back to blog

There has always been an unanswered question as to whether the investor affect the stock market performance or the market behavior affects the investors perception. Being in a quandary, a student approaches his professor and poses this question. This is the ensuing conversation.

Student: I am so intrigued by the current stock market performance. The volatility has increased multifold in the recent times. Who do we attribute to this fluctuation? Can you help me to figure this out?

Professor: I may not succeed but regardless, I will try. Let us start with the market. First, we know that the market players are the following – the promoters, domestic institutional investor, foreign institutional investor and the ever greedy retail investor. All these parties are present in the market bringing in their own resources. The data will show the levels of commitment of these players and basically answering the question, “What is at stake for them”? They are bound by a set of rules designed and implemented by the regulatory authorities (SEBI in India). Margin, payment, settlement time, commission etc., are all the part of regulation. Given this, the market responds to our collective behavior. For example, investors decide to sell a stock in large volume, the price of it drops humongously and the regulators have introduced a concept of circuit breakers to change the sentiment. The market needs high volume of liquidity (churning) and adequate number of players at any given time. The market has its own sentiment and also reflects the other markets behavior. Typically if the US Dow Jones index drops significantly, the Indian market Sensex responds in a similar way. Market analysis who make a living in this field rush to throw in their expertise by analyzing the given situation and attributing the volatility to people risk-return preferences, liquidity levels, interest rate changes, behavior or bond market etc. Their diagnosis varies and so no two analysts conclude the same way.

The market is running. It responds to the corporate profit situation, fiscal and monetary policies. It is capable of creating new high and new lows sometimes alternating between deep pessimism and extreme optimism. Recent Chinese stock market crash is a good example of extreme pessimism. Sometimes the market goes into a deep slumber. For example, Japanese Nikkei index was 38500 in 1989 and today it is 17100 after nearly 26 years. Market is the ultimate god which the investors must respect and adore with all their sincerity. Investors often called the market friendly, unreasonable and sometimes illogical. The market says that it accepts all explanation. Professors study the market to predict whether it is efficient, semi-efficient and even compare it to random walk. So you see predicting the short term market behavior is more challenging than climbing the Mount Everest (a recent movie on this topic is a big hit).

Student: Professor, I was expecting a short and sweet answer, but your explanation floors me.

Professor: Don’t worry. All are in the same boat including myself. The market is alluring charming and attracts one and all who want to taste a little bit of risk. Being in the market with a position is always adventurous while winning small or big increases your appetite and like caffeine and cigarette it is very addictive.

Student: Now that you have told me that there can be multiple opinion of the market at any given time. Can I have a similar explanation about investors?

Professor: I know you will ask that. Let me explain this in the next blog.

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