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tag:theconversation.com,2011:/us/topics/stocks-6225/articles stocks – The Conversation 2019-08-29T12:18:43Z tag:theconversation.com,2011:article/117948 2019-08-29T12:18:43Z 2019-08-29T12:18:43Z Should investors buy marijuana stocks?

Taking a whiff of the marijuana flower. AP Photo/Richard Vogel

Illinois recently became the 11th state to legalize marijuana for recreational use. As more states follow suit, legal cannabis spending is expected to grow over 200% from about US$9 billion in 2017 to $31 billion in 2022.

With these unparalleled increases in spending, marijuana stocks, including marijuana exchange-traded funds, with catchy tickers such as YOLO, an acronym for "you only live once," are becoming more common.

So should people add these stocks to their portfolios?

The rise of socially responsible investing

As a business ethicist, I know that socially responsible investing has become more popular, especially with millennials. Socially responsible investments experienced a 38% increase between 2016 and 2018. At the beginning of 2018 alone, $11.6 trillion was invested in socially responsible funds. This translates into $1 out of $4 of all U.S. invested funds.

Investors committed to being socially conscious have more choices than ever and can expect similar returns to traditional investors.

Moral basis for investing

While there is no set definition on what socially responsible investing entails, it goes beyond the fundamental view of Milton Friedman, an iconic economist, who claimed "the business of business is business" – in other words, making money or "profit."

In addition to profit, socially responsible investing focuses on what is known as the "triple bottom line." This means that companies also consider "people" and "planet," as part of responsible business practices.

Scholar David Vogel defines socially responsible investing as "practices that improve the workplace and benefit society in ways that go above and beyond what companies are legally required to do."

Socially responsible investors typically buy stocks in companies that have policies to mitigate climate change or support fair trade, but may avoid companies engaged in fossil fuels, tobacco, alcohol and arms production.

Most people would agree that such companies ultimately cause more social and environmental harm than good.

For instance, fossil fuels, while meeting the demands for a relatively cheap and consistent energy source, unequivocally contribute to air pollution and negatively impact human and environmental health.

The case of tobacco is similar. It is highly addictive and may seriously compromise a healthy and long life.

The case of marijuana

Taking a view on marijuana is more complex. The substance is used both medically and recreationally.

Marijuana use can cause harm, especially when used at a young age. The National Institutes of Health acknowledges that 30% of users develop dependence and withdrawal symptoms with the long-term use of marijuana. It can also lead to long-term and adverse changes to the brain.

The American Lung Association advises against smoking marijuana due to the risks it poses for lung health.

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 Medical marijuana plants being grown with special grow lights at a facility in Ravena, New York. AP Photo/Hans Pennink

However, marijuana also has some health benefits.

Even though marijuana is not recognized by the Federal Drug Administration as a medicine, the National Institutes of Health recognizes chemicals derived from the plant can help increase appetite, decrease pain, inflammation and nausea. The NIH also acknowledges that such derivatives may be useful in treating certain mental illnesses and addictions and some studies have shown it may be a weapon against opioid dependence.

Clinical trials hold the promise of finding more therapeutic benefits and possible treatments.

Medical marijuana stocks

So does owning marijuana stocks raise the same ethical issues as owning stocks in an alcohol or tobacco firm – or are they more like pharmaceutical stocks?

There are gray areas in socially responsible investing. Not all socially conscious investors have the same values, and not all companies create equal amounts of good.

I do think any socially responsible investor should stay away from recreational marijuana stocks due to the potential for addiction coupled with other health risks.

Medical marijuana stocks, on the other hand, appear to have more benefits than harms. When used for medical reasons, the therapeutic benefits seem to outweigh the health risks. In my view, socially responsible investors should feel free to include a medical marijuana stock in their portfolios if it aligns with their values.

Editor's note: This piece is part of our series on ethical questions arising from everyday life. We would welcome your suggestions. Please email us at email@example.com.

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Sandra Woien does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.
 A business ethicist explores whether cannabis stocks fit in with a socially responsible approach to investing. Sandra Woien, Lecturer of Philosophy, Arizona State University Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/122003 2019-08-21T12:32:30Z 2019-08-21T12:32:30Z How to invest if you're worried a recession is coming

Even the pros don't know what's up.  AP Photo/Richard Drew

Although the U.S. economy continues to grow and add jobs, talk of a recession is increasingly in the air due to a number of worrying signs.

Business investment and consumer confidence are taking a hit due to the growing economic jitters and uncertainty over the ongoing trade war with China. An important bond market recession warning – known as an inverted yield curve – is spooking investors. And policymakers are actively taking steps to bolster the economy, such as the Federal Reserve's recent decision to lower short-term borrowing costs. The Trump administration is even mulling a payroll tax cut to avert a downturn.

A question I'm often asked as a finance professor and a CFA charterholder is what should people do with their money when the economy is slowing or in a recession, which typically causes riskier assets like stocks to decline. Fear causes many people to run for the hills.

But the short answer, for most investors, is the exact opposite: Stick to your long-term plan and ignore day-to-day market fluctuations, however frightening they may be. Don't take my word for it. The tried and true approach of passive investing is backed up by a lot of evidence.

Most of us have money at risk

While we usually associate investing with hotshot Wall Street investors and hedge funds, the truth is most of us have a stake in financial markets and their ups and downs. About half of American families own stocks either directly or through institutional investment vehicles like mutual funds.

Most of the invested wealth average Americans hold is managed by professional investors who look after it for us. But the continued growth of defined contribution plans like 401(k)s – which require people to make choices about where to put their money – means their financial security increasingly depends on their own investment decisions.

Unfortunately, most people are not good investors. Individual investors who trade stocks underperform the market – and passive investors – by a wide margin. The more they trade, the worse they do.

One reason is because the pain of losses is about twice as strong as the pleasure of gains, which leads people to act in counterproductive ways. When faced with a threatening situation, our instinctive response is often to run or fight. But, like trying to outrun a bear, exiting the market after suffering losses is not a good idea. It often results in selling at low prices and buying higher later, once the market stress eases.

The good news is you don't need a Ph.D. in finance to achieve your investment goals. All you need to do is follow some simple guidelines, backed by evidence and hard-earned market wisdom.

Investing checklist

First of all, don't make any rash moves because of the growing chatter about recession or any wild gyrations on Wall Street.

If you have a solid investment plan in place, stick to it and ignore the noise. For everyone else, it's worth going through the following checklist to help ensure you're ready for any storm on the horizon.

Define clear, measurable and achievable investment goals. For example, your goal might be to retire in 20 years at your current standard of living for the rest of your life. Without clear goals, people often approach the path to getting there piecemeal and end up with a motley collection of investments that don't serve their actual needs. As baseball legend Yogi Berra once said, "If you don't know where you are going, you'll end up someplace else."

Assess how much risk you can take on. This will depend on your investment horizon, job security and attitude toward risk. A good rule of thumb is if you're nearing retirement, you should have a smaller share of risky assets in your portfolio. If you just entered the job market as a 20-something, you can take on more risk because you have time to recover from market downturns.

Diversify your portfolio. In general, riskier assets like stocks compensate for that risk by offering higher expected returns. At the same time, safer assets such as bonds tend to go up when things are bad, but offer much lower gains. If you invest a big part of your savings in a single stock, however, you are not being compensated for the risk that the company will go bust. To eliminate these uncompensated risks, diversify your portfolio to include a wide range of asset classes, such as foreign stocks and bonds, and you'll be in a better position to endure a downturn.

Don't try to pick individual stocks, identify the best-performing actively managed funds or time the market. Instead, stick to a diversified portfolio of passively managed stock and bond funds. Funds that have done well in the recent past may not continue to do so in the future.

Look for low fees. Future returns are uncertain, but investment costs will certainly take a bite out of your portfolio. To keep costs down, invest in index funds whenever possible. These funds track broad market indices like the Standard & Poor's 500 and tend to have very low fees yet produce higher returns than the majority of actively managed funds.

Continue to make regular contributions to your investments, even during a recession. Try to set aside as much as you can afford. Many employers even match all or some of your personal retirement contributions. Unfortunately, most Americans are not saving enough for retirement. One in 4 Americans enrolled in employer-sponsored defined contribution plans does not save enough to get the employer's full match. That's like letting your employer keep part of your salary.

There's one exception to my advice about standing pat. Let's suppose your long-term plan calls for a portfolio with 50% in U.S. stocks, 25% in international stocks and 25% in bonds. After U.S. stocks have a good run, their weight in the portfolio may increase a lot. This changes the risk of your portfolio. So about once a year, rebalance your portfolio to match your long-term allocation targets. Doing so can make a big difference in performance.

Always keep in mind your overall investment plan and focus on the long-term goals of your portfolio. Many market declines that were scary in real time look like small blips on a long-term chart.

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 Warren Buffett knows a thing or two about investing. AP Photo/Nati Harnik

Turbulence ahead

In the long run, this approach is likely to produce better results than trying to beat the market – which even pros tend to have a hard time doing.

Billionaire investor Warren Buffett demonstrated this by easily winning a bet that a simple S&P 500 index fund could beat a portfolio of hedge funds – supposedly the savviest investors out there, at least judging by the high fees they charge.

In the words of legendary investor Benjamin Graham: "The investor's chief problem and even his worst enemy is likely to be himself." Graham, who mentored Buffett, meant that instead of making rational decisions, many investors let their emotions run wild. They buy and sell when their gut – rather than their head – tells them to.

Trying to outsmart the market is akin to gambling and it doesn't work any better than playing a lottery. Passive investing is admittedly boring but is a much better bet long-term.

But if you follow these guidelines and fasten your seatbelt, you'll be able to ride out the current turbulence.

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Alexander Kurov tidak bekerja, menjadi konsultan, memiliki saham, atau menerima dana dari perusahaan atau organisasi mana pun yang akan mengambil untung dari artikel ini, dan telah mengungkapkan bahwa ia tidak memiliki afiliasi selain yang telah disebut di atas.
 A growing number of investors, policymakers and others say the US economy may be at risk of spiraling downward. A finance professor explains how to ride it out. Alexander Kurov, Professor of Finance and Fred T. Tattersall Research Chair in Finance, West Virginia University Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/110092 2019-01-18T11:41:35Z 2019-01-18T11:41:35Z What's an index fund?
The creation of the index fund in 1975 revolutionized investing, lowering costs for millions of ordinary investors.

Their inventor John Bogle died on Jan. 16 at the age of 89.

Bogle took a complex universe of thousands of stocks and reduced it to a simple, singular entity, the index fund. Through index funds, investing in the stock market became easy, and one could do so at low cost while minimizing risk.

Practitioners and academics have researched the drivers and consequences of index fund investing – myself included. Here is some of what we know.

Investing before index funds

In the 1970s, academics and others began finding that many highly paid stock pickers do not outperform broad market indices. That is, investors could earn higher returns by simply holding a diversified portfolio of stocks and avoiding speculation altogether.

But at the time, the average investor didn't have an easy way to this because an investment vehicle for such diversification did not yet exist.

So Bogle stepped in and created the index fund.

An easy way to diversify

In a nutshell, index funds are designed to give investors exposure to a diversified set of stocks at a very low cost.

The name "index" reflects the idea that by buying the fund an investor in effect immediately owns a broad index of the underlying stocks. All you must do is pay an intermediary – like Vanguard, the investment company Bogle founded, which now manages US$5.1 trillion in assets – a small, built-in fee in exchange for spreading your money out across the market.

In part, that's because index funds are bought and sold just like individual stocks and many even have their own stock symbols.

For example, if you want exposure to a mix of all the companies in the S&P 500 index, you can buy the stock VOO, and your money will automatically be invested in a value-weighted portfolio of the S&P 500 companies. If you want to divest, simply sell your shares of VOO.

Why they're so popular

The underlying logic of index funds still prevails today.

Academics regularly find that stock pickers – who continue to be highly paid – do not outperform the market, on average. It should thus not be surprising that, according to Moody's, nearly one-third of all investments in the U.S., or almost $6 trillion, are now in index funds or other passive investments. Analysts expect this amount to increase further over the next decade.

Economies of scale resulting from their popularity have caused the fees for some index funds to hit zero. And by one estimate, Bogle's creation is saving investors $100 billion every year.

Bogle's innovative investment philosophy overturned an industry, which in my view makes him one of Wall Street's superstar investors.

Jordan Schoenfeld does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.
 The index fund revolutionized investing for millions. Its founder died on Jan. 16. Jordan Schoenfeld, Accounting Faculty, Georgetown University Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/101297 2018-08-08T21:04:38Z 2018-08-08T21:04:38Z What is insider trading, the crime Rep. Chris Collins was charged with?
The arrest of Congressman Chris Collins shines light on one of the sexier crimes that the securities laws has to offer: insider trading.

It's the subject of many iconic movies like "Wall Street," television shows like "Billions" and real-life scandals involving celebrities, politicians and others.

But despite all the media attention, very few people actually know what insider trading is under the law and how it gets people into trouble. As finance experts, we are here to fill that gap.

What is insider trading?

As its most basic, insider trading is when someone – usually a corporate insider – buys or sells securities such as a stock or bond based on "non-public information."

For instance, Martha is a board member at Company X and learns of an incredible breakthrough at her company that hasn't been disclosed to the public. If she then uses that information to buy her company's stock – knowing that the stock price will go up after the announcement – Martha is likely guilty of insider trading.

Under current laws, the insider can also get into trouble if he or she shares that information with others – who could face prosecution as well if they make a trade using the information.

'Billions' on insider trading.

Why is it illegal?

For much of the 20th century in the U.S., insider trading was not generally considered illegal. It was only in the 1950s that various court rulings strengthened the power of Wall Street's beat cop – the Securities and Exchange Commission – to go after inside traders under federal securities law.

Under the classical legal theory for insider trading, an insider – whether an employee or a corporate director – has a fiduciary obligation to a company to keep secret information secret. Insiders who breach that duty by either trading on the information or sharing it for personal benefits violate that duty. This appears to be the case with Collins.

But what if the stock you traded wasn't from a company to whom you owed a fiduciary duty?

That was at the heart of a 1997 Supreme Court case that spawned something known as the misappropriation theory, which broadened what was considered illegal insider trading. In that case, attorney James O'Hagan used information he gained from his position at his firm to trade in another company's stock. Since it wasn't O'Hagan's client, he argued, there was no duty and, hence, no breach.

The court disagreed. Since O'Hagan used confidential information that was given to him to perform his job and instead used it for his personal gain, he breached his duty and was therefore found guilty of insider trading.

Since then, prosecutors have used this theory to find wives who trade based on marital secrets, therapists who trade based on therapy sessions and even hackers who trade based on computer theft all to be guilty of insider trading.

As for Collins, he sat on the board of biotechnology company Innate Immunotherapeutics. He was also the Australian company's largest shareholder. When Collins learned that a trial involving a new multiple sclerosis drug failed, he allegedly sold shares in the company – to avoid significant losses – and passed along that information to his son, who in turn, shared it with others.

Not quite the plot of a "Billions" story line, but, give it a year and we're sure that Hollywood can come up with something.

The authors do not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.
 Insider trading, like what Rep. Chris Collins is accused of engaging in, is one of the sexier crimes in securities law. Jena Martin, Professor of Law, West Virginia University Karen Kunz, Associate Professor of Public Administration, West Virginia University Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/100925 2018-08-06T10:38:44Z 2018-08-06T10:38:44Z Why adjusting capital gains for inflation makes economic sense
The Trump administration is considering a significant change to the way capital gains on investments like stocks, businesses and real estate are calculated.

The administration wants to allow investors to use inflation when determining the gain they get when they sell an asset, which would usually mean reducing the profit – as reported to the IRS – and thus the amount that's taxable. Based on what is known about the plan, it would reduce taxes by about US$100 billion over 10 years.

I'll let others debate the implications for certain taxpayers and the impact it would have on the federal deficit. Instead, I'll focus on why the proposal to adjust capital gains for inflation is a good one, the rationale for which has been argued by financial economists – including me – for decades.

Capital gains and inflation

Treasury Secretary Steve Mnuchin recently told The New York Times that his department is studying a regulatory change that would allow taxpayers to use inflation – or the change in the price of goods and services over time – in determining how much they owe when they sell an asset that has increased in value.

Capital gains work like this. Let's say you bought a stock five years ago for $100. Today you sell it for $150. Based on current rules, you'd have a long-term capital gain of $50, which would then be taxable at a rate as high as 20 percent. Gains on assets sold less than a year after purchase are taxed at individual rates.

Under the proposed change, you could adjust the initial price, or basis, by the effect of inflation over that five years. The basis would thus rise to $108, reducing the gain to $42 and lowering the tax owed as well.

Adjusting a financial "gain" for the effects of inflation is nothing new. In the late 1940s, unions were among the first to advocate for automatic adjustments to an income or other recurring payment. In their case, they wanted members' wages adjusted for inflation every year to preserve their purchasing power.

Since then, so-called cost of living adjustments have been applied to a variety of financial payments, such as rents, Social Security benefits and royalties.

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 Treasury Secretary Steve Mnuchin says his department is studying whether it can make the regulatory change on its own. AP Photo/Pablo Martinez Monsivais

Why extending this to gains makes sense

So why not do the same for capital gains?

Let's look at our example again. The effects of inflation mean you need $108 today to get the same purchasing power as $100 had in 2013. But let's say instead of a sale price of $150, you can only get $109 for the stock. Under current rules, that would be a taxable profit of $9. But the real or inflation-adjusted profit, factoring in actual purchasing power, is only $1.

At a capital gains tax rate of 15 percent, that would mean Uncle Sam would take $1.35, and you'd be 35 cents poorer than you started.

The data suggest this is a big problem. A study of the impact of inflation on capital gains in 1978 by economists Martin Feldstein and Joel Slemrod showed that $4.5 billion in nominal capital gains on corporate stock in 1973 became a real loss of almost $1 billion.

Some countries such as the U.K. and Ireland already adjust capital gains taxation for inflation. A study by economist Barry Bracewell-Milnes found that its use reduced the "burden and inefficiencies" of capital gains taxes, which he argued are economically damaging because they yield little revenue yet create many administrative and compliance costs.

The benefits of adjustment is greatest, of course, when inflation is especially high, as it was in the U.K. around the time it introduced indexing. While inflation has been fairly low in the U.S. for decades, it soared in the 1980s and could climb again.

As for the broader impact on U.S. tax policy, John Rico, a senior analyst at the Penn Wharton Budget Model initiative, concluded that even though indexing capital gains to inflation would accrue mainly to the top 1 percent of earners, it would not meaningfully alter the distribution of the tax burden.

All in all, I believe it makes a lot of economic sense to index capital gains to inflation. By acknowledging that inflation does in fact change the economic value of these gains, this would optimize investment decisions by encouraging more long-term planning and help the economy run more efficiently. It would also, in a small way, discourage short-term thinking – something I've fretted about in the past.

Dale O. Cloninger does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.
 The Trump administration is considering a change to how capital gains taxes are calculated that would save investors roughly $100 billion over a decade. Dale O. Cloninger, Professor Emeritus, Economics & Finance, University of Houston-Clear Lake Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/97842 2018-06-26T10:41:20Z 2018-06-26T10:41:20Z Bitcoin price manipulation puts trust in cryptocurrencies at risk
Cryptocurrencies like bitcoin have grown in popularity in large part because they can be bought and sold without a government or other third party overseeing everything. But there's a flipside: Unlike in markets for other assets such as stocks or bonds, it makes it much harder to uncover price manipulation and fraud.

But that's what the Justice Department likely intends to do. In May, it opened a criminal investigation to examine whether there has been price manipulation in the cryptocurrency markets. While it wasn't clear what time period investigators are looking at, it's likely that they're focusing on the sharp rise and fall that occurred in late 2017 and early 2018.

The impact of illicit cryptocurrency trading could be large. For example, bitconnect, once the seventh-biggest digital coin, collapsed in a matter of hours in January, costing investors hundreds of millions of dollars and eroding trust in legitimate cryptocurrencies.

We have been researching digital currencies for the last several years. Our most recent paper, published in the Journal of Monetary Economics earlier this year, found evidence of fraudulent behavior in 2013 and 2014, when prices soared and then tumbled over several months.

Could the failure to root out and prevent this kind of abuse erode trust in digital currencies?

Why cryptocurrency fraud matters

First it's worth considering why anyone should care about digital currencies. Their total market capitalization of about US$350 billion, for example, is just a fraction of the size of the global stock market, which is closing in on $100 trillion.

Still, cryptocurrencies have soared in value in a very short period of time, climbing from just $14 billion in January 2014. And since bitcoin became the first digital currency in 2009, hundreds have launched, with more than 800 active today.

While cryptocurrencies can in theory be used to purchase goods and services – they are called currencies after all – they must first attract large numbers of merchants and consumers, which hasn't happened yet. That's why, currently, crytocurrencies are primarily purchased as financial assets like stocks and bonds that buyers hope will appreciate in value over time.

But unlike currencies, financial assets have a tendency to fluctuate wildly.

And since investors without a lot of experience with risky assets are increasingly purchasing cryptocurrencies, that puts them at risk when there's a rapid rise and fall in prices.

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 Bitcoin trader Kolin Burges stands in protest outside an office building housing Mt. Gox, which housed a bitcoin exchange in Tokyo. AP Photo/Shizuo Kambayashi

Bitcoin's first roller-coaster ride

That's what happened to the price of bitcoin in 2013, when it jumped from around $150 in October to over $1,000 in December before dropping over 50 percent weeks later. By early 2014, several people who traded on Mt. Gox, the leading bitcoin currency exchange at the time, had identified what they considered "suspicious activity" on the exchange and wrote extensively about it.

Our paper, titled "Price Manipulation in the Bitcoin Ecosystem," examined this suspicious trading activity.

We were able to conduct the analysis because when Mt. Gox collapsed in early 2014, its transaction history data got leaked. This gave researchers like us access to approximately 18 million transactions from April 2011 to November 2013. The key is that these data linked transactions to user accounts – though not their real identities. With this information, we were able to link suspicious trades to accounts.

Our analysis of the data confirmed much of what was reported in the "anonymous" documents. In the paper's appendix, we go into great detail to show why two trading mechanisms in particular should be considered suspicious. The first, known as the "Markus bot," involved reporting trades that did not exist. The second, or "Willy bot," involved trades in which Mt. Gox itself bought bitcoins from its own customers but did not let many of them withdraw the proceeds from their accounts.

In a trial in Japan in 2017, former Mt. Gox CEO Mark Karpeles confirmed that the exchange operated the "Willy" accounts and that the trades were issued automatically.

The trading activity of these bots led to significantly increased trade at Mt. Gox and other exchanges as well. As a result, prices rose when the bots were active.

We believe this is one type of suspicious trading that will likely be investigated by the Justice Department following the massive rise and fall in the price of bitcoin that occurred around the end of 2017.

Investors go for another ride

Last year was a banner one for cryptocurrencies, particularly bitcoin, which soared from $1,000 at the end of 2016 to a peak of over $19,000 in December.

The real spike, however, came in November when the price tripled in less than a month. The euphoria was over as quickly as it started as bitcoin plunged to $7,000 by February.

University of Texas finance professors John M. Griffin and Amin Shams released an SSRN working paper in June concluding that price manipulation likely led to more than 50 percent of the meteoric rise in bitcoin in 2017. Their focus was on the flow of bitcoin going in and out of Bitfinex, which according to an article in The New York Times is one of the largest and least regulated exchanges in the industry.

Beyond bitcoin, the potential for price manipulation is even higher in digital currencies with much less trading volume.

Moving forward

Commenting about the market for digital coin offerings – where cryptocurrencies go public – Security and Exchange Commission Commissioner Robert Jackson remarked in April that "investors are having a hard time telling the difference between investments and fraud."

The challenge for investigators and others in detecting price manipulation today is that there isn't sufficient transparency about trading patterns of individuals, as there is in more regulated assets like stocks and bonds traded on stock exchanges like the Dow Jones and Nasdaq. In our research, we were fortunate to have internal trading data made public following Mt. Gox's collapse. We do not have the same luxury today.

The key lesson is that cryptocurrency markets need increased cooperation between financial regulators and trading platforms. For example, exchanges could be required to share information about the trading behavior of individuals with very large positions. This would help ensure that the trades taking place are in fact legitimate and reflect real sales.

The consequence of not taking steps in this direction is likely a loss of faith in cryptocurrencies.

Neil Gandal has received funding for this from the following grants for this research project: The US-Israel Binational Science Foundation and The Blavatnik Interdisciplinary Cyber Research Center at Tel Aviv University. Neil Gandal is a Research Fellow at the Centre for Economic Policy Research (CEPR)

Tyler Moore receives funding from US National Science Foundation Award No. 1714291. He is the director of StopBadware and an Editor in Chief of the Journal of Cybersecurity.
 Evidence of past price manipulation of bitcoin and the just-launched Justice Department investigation highlight the need to take steps against cryptocurrency fraud. Neil Gandal, Professor of Economics, Tel Aviv University Tyler Moore, Assistant Professor of Computer Science and Tandy Chair of Cyber Security and Information Assurance, University of Tulsa Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/92655 2018-04-10T10:39:02Z 2018-04-10T10:39:02Z Stock investors on higher floors take more risks – here's why

Do Wall Street's high-rises fuel risky behavior?  ErickN/Shutterstock.com

Stocks have been on a bumpy ride lately as concerns over a trade war prompt investors to rethink their appetite for risk.

But what prompts people to take risks in the first place? A desire for wealth? Fear of failure? Personality? Gender? Age? Education? Race?

While studies have found that each can play a role, research I recently conducted with colleagues found another surprising factor: their location inside buildings, specifically their distance from street level.

Business and the environment

Winston Churchill, himself known as a risk-taker, famously said: "We shape our buildings and afterwards our buildings shape us."

Yet over 75 years since Churchill said this, we still don't know all that much about the role buildings play in shaping how we behave.

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 Winston Churchill understood that buildings can affect our behavior. AP Photo

While our understanding of the human psyche and behavior has changed radically over the past few decades thanks to advancements in various branches of psychology and neuroscience, study of the link between humans and their physical environment seems to have mostly been on hiatus since the 1970s.

Despite this, a peculiar group of academics have made great strides in recent years when it comes to understanding human-environment interactions: business researchers.

A growing number of scholars in business schools – including my own – have been investigating how people's financial and consumer decisions are affected by factors in the built environment. Labels have emerged to describe these findings, such as "atmospherics," "sensory marketing," "servicescapes" and "embodied/grounded cognition."

For instance, studies have shown that people are more creative in rooms with high ceilings, more likely to vote in favor of educational initiatives when they are physically in a school, seek more variety when shopping in narrow aisles, prefer romantic movies in cold rooms and are more likely to donate to charities in brightly lit settings.

While the burgeoning literature in this area is often disjointed and scattered across fields such as marketing, finance and organizational studies, these findings are nonetheless fascinating.

What causes risk-taking

So what does all this have to do with risk?

Most people would like to think that they are stable decision-makers, and that their attitudes toward risk are part of their personality. They may describe themselves as chronically hotheaded, overcautious or somewhere in between – but always consistently so.

However, research has shown that risk-taking is a function of situations as much as traits. Behavioral economics pioneers Daniel Kahneman and Amos Tversky, as well as others that followed, have found that risk preferences and behaviors can shift dramatically depending on a multitude of extrinsic factors, such as how a decision is framed, resources available to the decision-maker and social pressure.

Yet research on the impact of physical environments on risky decisions is scant. Until recently, the only thing we really knew about it is that people who are chronic risk-takers often seek the thrill experienced in high elevations. Think skydiving, bungee-jumping, skiing and so on.

My colleagues and I wondered if the opposite is true. In other words, does being placed at high elevations make people more risk-seeking than they would be, say, at street level?

In a series of studies recently published in the Journal of Consumer Psychology, we found that risk tendencies change drastically depending on people's location in buildings, specifically what floor they are on.

 <img alt="" src="https://images.theconversation.com/files/213955/original/file-20180409-114105-1oel23t.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/213955/original/file-20180409-114105-1oel23t.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=470&fit=crop&dpr=1 600w, https://images.theconversation.com/files/213955/original/file-20180409-114105-1oel23t.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=470&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/213955/original/file-20180409-114105-1oel23t.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=470&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/213955/original/file-20180409-114105-1oel23t.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=591&fit=crop&dpr=1 754w, https://images.theconversation.com/files/213955/original/file-20180409-114105-1oel23t.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=591&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/213955/original/file-20180409-114105-1oel23t.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=591&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
 Taking an elevator can be risky. Everett Collection/Shutterstock.com

Going up?

We started exploring this topic by collecting data on fund performance and office location from over 3,000 hedge funds, which collectively oversee more than $500 billion in assets.

We then examined the correlation between hedge fund volatility and office location in terms of number of stories above ground. We found that as the elevation of hedge fund managers' offices increased, they were more willing to take risks that resulted in more volatility. This was true even when statistically controlling for factors such as total assets, fund strategy and several other variables that could have led more resourceful hedge funds to occupy expensive offices that are often found on higher levels of buildings.

Next, we conducted four field studies across 22 U.S. states to explore the causal link between elevation and risk and to explain how and when this phenomenon occurs.

One of these studies involved conducting, quite literally, an "elevator pitch" – or making a proposal in the time it takes to get from one floor to the next. Essentially an experimenter would randomly meet with people in an elevator at the Renaissance Center, a 73-floor skyscraper in Detroit, Michigan. While traveling up or down, the experimenter would pose a potential investment decision (a 30-second elevator pitch, if you would) which involved deciding how to allocate a certain amount of money between a low-risk savings account and a high-risk investment.

We found that people going up were much more likely to invest in the risky (rather than safe) option compared with those going down. This was true even when we asked the same person about two hard-to-compare investments, once while going up and the other on the way down. We used various other controls to ensure there was no "order" effect.

In another study, we randomly placed participants on the ground floor or third floor of a building and asked them to make 10 decisions with differing degrees of risk and payoff. We found that people implicitly feel more powerful in higher elevations, consequently leading to increased risk-seeking behavior – often in an irrational manner. This is in line with previous psychological findings suggesting that individuals who feel powerful are more likely to seek risks.

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 'Elevation' sickness? AP Photo/Richard Drew

No risk-takers in Kansas

What these results suggest is that while buildings people occupy everyday probably affect their decisions at one point or the other, the impact may be more consequential for individuals who work in high-rises and manage millions of dollars of investments.

Loftier office location may be one element that nudges money managers to take unreasonable risks, whether during the subprime mortgage crisis in 2008, historic volatility in the cybercurrency market or in the record stock market surge that ended in January.

Does this mean that moving Wall Street from the skyscrapers of Manhattan to the flat plains of Kansas will save us from the next recession? Probably not.

But the point to remember is that, as Churchill alluded, the buildings that surround us can have a powerful impact on our decisions. And scientists have barely scratched the surface when it comes to understanding the complex ways in which it can shape us and subtly guide our thoughts and actions.

Sina Esteky does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.
 Business scholars have found that our physical environment can influence us in a variety of surprising ways – including by prompting us to engage in riskier behavior depending on elevation. Sina Esteky, Assistant Professor of Marketing, Farmer School of Business, Miami University Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/91874 2018-02-14T15:18:00Z 2018-02-14T15:18:00Z Why does inflation make stock prices fall?

Even the big, bad Wall Street bull is scared of inflation. AP Photo/Richard Drew

Stock markets have been on a wild ride recently, plunging one day and then soaring the next.

Pundits have offered many reasons for the biggest stock market swoon in two years. One of the most frequently blamed culprits was the threat of inflation, which loosely means an increase in consumer prices over time.

That threat became a little more real after the latest data, released on Feb. 14, showed inflation in January rising more than expected, sending stocks and bonds lower.

What would prompt something so seemingly banal to send investors into a state of craziness and even panic? A closer look at inflation – a topic I've studied closely – and how it affects markets offers some answers. It also hints that an economic slowdown is closer than you may think.

What is inflation?

Inflation is defined as the rate of change in the prices of everything from a bar of Ivory soap to the costs of an eye exam.

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 Better, worse, same? It's all in the CPI. Mega Pixel/Shutterstock.com

In the U.S., we measure inflation using something called the consumer price index. Simply put, the CPI is the average price of a basket of goods and services that households typically purchase. It's used throughout the economy, for example to set pay raises or to adjust benefits for retirees.

The CPI increased 0.5 percent in January from the previous month on a seasonally adjusted basis, more than economists had forecast and the most since September.

Over the previous 12 months, the index gained about 2.1 percent on a nonseasonally adjusted basis, meaning the price of most goods and services rose by about that amount on average during the period. Some, such as hospital services, climbed at a faster pace than the average (6 percent), while other categories rose more slowly or even declined, such as airline fares, which fell 5.1 percent.

Although inflation is still fairly low today, this hasn't always been the case. In 1979, inflation exceeded 11 percent, a trend that persisted into the early 1980s.

Some observers are now worried it's about to start accelerating again.

The present value of money

So what spooks stock investors about inflation? To answer that, let's examine the two ways inflation directly affects stock prices. The first concerns how we value future income.

When you purchase a stock, for example in Walmart or IBM, you are actually buying a long stream of future cash flows based on the profits of the company. The value of the company (and its stock price) is based on how much these future cash flows are worth today, a finance concept called "present value." The present value of any sum of money expected to be collected in the future is computed by factoring in the impact of interest rates and inflation.

For example, let's say you win the lottery and you're offered either US$10,000 in a year's time or $9,600 right now. What should you do? Well, if you're acting rationally and you don't have any urgent debts that need paying off, you would try to determine what that $10,000 is currently worth. To do so, you would divide it by 1 plus the interest rate you could readily get at a bank, let's say 3 percent (we're assuming that there is no inflation). So the present value of $10,000 a year from now would be $9,709 – which means it's best to be patient and wait, rather than take the money now.

Now let's imagine the same scenario but with inflation, which is expected to be 2 percent during the period. Inflation causes the bank rate to be 5 percent, and as a result that 10 grand is actually worth only $9,524 today. In which case, take the $9,600.

Because inflation made the "discount rate" higher, the value today of the future $10,000 was reduced. The same thing happens to stocks. Since a stock's price is just the risk-adjusted present value of the company's future cash flows, a rise in inflation will cause it to drop as well.

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 When investors buy Walmart stock, they're really buying the expectation that all these customers will keep coming back and generating cash flows in the future for the company. AP Images for Walmart/Gunnar Rathbun

Inflation's flip side

A second way inflation directly affects stocks has the opposite effect. That is, it should cause them to increase in value.

Rising prices means companies are able to make more money from every computer game, sofa or pastry they sell. A baker, for example, who sold bread for $5 a loaf increases the price to $5.50 because of strong demand. While the cost of the flour and yeast may have also climbed at the same pace, the baker still makes more money because profit goes up too.

That leads to higher future cash flows and thus a higher present value today.
 These two effects of inflation should in theory cancel each other out. And yet stock prices are usually hammered when inflation rises. So what's going on?

There's lots of evidence, including my own research, that many investors suffer from something called "inflation illusion." They worry about the present value effect of inflation of stocks but they ignore the growth in cash flows and profits that result from higher inflation. This results in stock prices falling when they shouldn't.

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 Stock markets have been a sea of red lately. AP Photo/Sadiq Asyraf

Slowdown on the horizon

However, there's a third, indirect way inflation affects stocks. And this might be what is causing the concerns in the markets today. This effect has inflation playing the role of a canary in a coal mine, warning that bad times are coming.

To understand this, we have to consider how inflation varies through the business cycle, which is a way of measuring the growth of the economy from the beginning of an expansion to the end of a recession.

At the beginning of a cycle, inflation is often low. (It was practically nonexistent or even negative following the financial crisis of 2008.) But as the economy heats up and people have more money to spend (as is the case now), companies begin to sell more goods and services at steadily increasing prices, earning higher profits, while most people are able to find work.

As more stuff is being created and sold in the economy, the demand for raw materials and workers increases. Besides pushing up prices, this can also result in higher wages. The fastest increase in take-home pay in nine years was another "warning sign" that spooked investors recently.

This is where we are now. If left unchecked, inflation could spike, which would likely cause the economy to slow down quickly and unemployment to increase. The combination of rising inflation and unemployment is called "stagflation," and is feared by economists, central bankers and pretty much everyone else. It's what can cause an economic boom to suddenly turn to bust, as we saw in the late 1970s.

This is where the Federal Reserve steps in. The U.S. central bank has the ability, through various tools, to manipulate short-term interest rates. So before the economic party gets out of hand and stagflation takes hold, the Fed steps in to calm things down by increasing the cost of borrowing in an effort to gradually slow the economy rather than let it crash and burn.

Think of the Fed as the sensible person telling everyone to go home at midnight instead of partying until the early hours. It'll spoil the fun at midnight, but we'll all be happier the next day.

Is the party over?

Back to the current turmoil. The latest CPI figures suggest inflation may be accelerating, but it won't be clear until we get a couple more readings.

For now, it's mostly just the threat of inflation that's causing trouble as investors begin to realize that the party is getting a little too crazy and that the Fed is going to step in and slow things down a bit. In other words, inflation is warning sign that an economic slowdown is coming – whether gradually executed by the Fed or abruptly by a spike in inflation.

So if all of this is understood, why did the market crash? Investors, naturally, want to stay at the party as long as they can. It is only when they see others heading for the exits that they realize maybe it's time they left too, prompting a rush to the door. Thus the market tanks.

This is why a market can appear to be doing great and then suddenly fall at the first hint of inflation.

This is an updated version of an article originally published on Feb. 12, 2018.

Richard S. Warr does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.
 While many market observers blame growing concerns about inflation for the stock market crash, the real culprit may be fears that the economy is about to slow. Richard S. Warr, Professor of Finance, North Carolina State University Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/91307 2018-02-06T11:37:01Z 2018-02-06T11:37:01Z Why the global stock market crash doesn't really matter

Another jittery day on Wall Street.  Reuters/Brendan McDermid

Stocks, which only recently were hitting a new record practically every other day, suddenly seem to be in free fall. Or at least on a very wild ride.

Global stock markets plunged on Feb. 5, continuing the already precipitous decline from the week before. The Dow Jones industrial average, one of the most widely followed indexes, fell by almost 1,200 points, a 4.6 percent loss and the biggest point decline on record. Put another way, the world's 500 richest people lost about US$114 billion in a single day.

Since the Dow's record peak of 26,617 on Jan. 26, the index has fallen almost 9 percent. This brings it close to what is known as a "correction," which is often described as a fall of 10 percent. Corrections are simply a large enough fall in stock prices to get some people to believe the market's upward trajectory has stopped. We'll be in a "bear" market if losses reach 20 percent.

What does this mean for investors and the rest of us? In my view, there are three important ideas to keep in mind as we assess the impact of a plunging stock market on the economy and our wallets.

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 People were in panic as stocks began to collapse in October 1929. AP Photo

Don't panic

First, the stock market often makes very dramatic moves in a short period of time, and extreme volatility like Monday's occasionally occurs. One of the most famous market plunges occurred in 1929, at the start of the Great Depression.

On Oct. 25 1929, a Friday, the Dow Jones industrial average closed at 301. The following Monday, dubbed "Black Monday" in trading lore, the Dow closed at 260, a drop of 13.5 percent. Then the next day, called "Black Tuesday," the Dow fell to 230 points, a loss of 11.7 percent.

People were in a panic after only two days of steep losses. On Wednesday, which has no moniker, the Dow reversed course and rose up to 259. This rise almost entirely wiped out the previous day's fall.

In other words, in the space of less than 36 hours, the Dow fell and then rose around 12 percent. This whipsaw action means the stock market is not a place for investors who are faint of heart – and many people's savings and investments were wiped out as a result. But it also means that just because the stock market has large losses today does not means these large losses won't be quickly reversed in the future. (Perhaps even as you read this article, the market is going up again.)

Main Street vs. Wall Street

Second, Wall Street does not directly affect Main Street.

Falling or rising stock prices, even when the market changes dramatically, typically do not have a large or immediate effect on sales at stores, restaurants or other retailers. One reason for this is that people spend only a portion of their wealth each year.

Few people pay current bills and expenses from their stock market accounts. Instead, most people base their day-to-day spending decisions on their paycheck and other sources of income, not on their stock market holdings. Instead, stocks are often held to achieve long-term goals like retirement, a child's or grandchild's education, or a place to store money until needed to make a major purchase.

Moreover, when wealth increases, like when the stock market or housing market rises in value, people often spend only a fraction of that. When wealth decreases, many people don't cut back their purchases on a dollar-for-dollar basis.

Economists call this change in spending the "marginal propensity to consume out of wealth," and many believe the change in spending is around 4 percent of the total change in wealth. This means that whenever the value of people's stock market holding goes up or down, spending at stores, restaurants and other retailers changes by only a small fraction.

The 4 percent spending figure might even be too high. Research by James Poterba and Andrew Samwick from the mid-1990s investigated what happened when the stock market went up, and they found "little evidence that luxury spending rises in the wake of rising stock prices." Since other economic research suggests the 4 percent figure might be too low, it is likely the figure is about right.

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 Feeling any poorer? AP Photo/Nati Harnik

Relatively few own stock

The third idea to understand is that any dramatic drop or rise in the stock market affects relatively few people in the U.S. Many families have no savings, and, among those that have saved, not all have invested in the stock market.

Every three years, the Federal Reserve surveys thousands of American families about their finances. The effort is called the Survey of Consumer Finances. Its latest data show that just 14 percent of all U.S. families directly own shares or stock mutual funds.

So if you're one of those 14 percent, Warren Buffett, for example, you care a great deal – he lost $5.1 billion on Feb. 5 alone. But for the other 86 percent, the daily fluctuations don't matter quite as much since they don't have a direct stake in the outcome.

Moreover, the amount of money invested by this select group of families that directly own stocks is quite low. Half of all families who directly invested in the stock market has $25,000 or less. That is not to say that everyone who invests socks away only a small amount. In recent days, the wealth of a small group took a significant hit, with the wealthiest losing about $250 billion since last week.

It is also important to note that some people who don't directly own stocks are still affected by the market's performance. Pensions and money stored in retirement accounts experience the market's ups and downs, so some retirees' income is affected. About 37 percent of U.S. stocks were held in retirement accounts in 2015, a sharp rise from the recent past.

However, changes in future retirement income typically don't affect spending today. Also, some people have options to buy their company's stock in the future. While many of these options lost value recently, most people could not have spent the money from these options until years in the future.

What, me worry?

What all this means is that the next time you hear that the stock market has set a new record low, or even a record high, know that it only affects a small proportion of Americans.

Among the families that are directly affected, the average will likely change its spending habits by only a little bit. Amazon's Jeff Bezos, for one, is unlikely to change his lifestyle much just because he lost $3.26 billion in a day – as he still has $116 billion to spare.

Finally, a plunge today does not rule out a dramatic rise in the future.

Cratering stocks makes big news. However, like many headline news stories, there is only a small chance the news of a single-day plunge in stock values will have an immediate and direct impact on your life.

This an updated version of an article originally published on Aug. 24, 2015.

Jay L. Zagorsky does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.
 An economist explains why the Dow Jones industrial average's biggest-ever one-day drop shouldn't bother you too much. Jay L. Zagorsky, Economist and Research Scientist, The Ohio State University Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/89121 2017-12-19T01:41:32Z 2017-12-19T01:41:32Z Exxon Mobil's about-face on climate disclosure

Protesters have sought for years to force Exxon Mobil to disclose the risks it faces due to climate change and to do more to minimize them.  AP Photo/LM Otero

Exxon Mobil Corp. has vowed to do a better job in disclosing the risks it faces from climate change starting "in the near future" after bucking pressure to do that for years.

Until now, shareholders and bondholders had no choice but to rely on informed guesswork by outsiders to divine how the nation's largest fossil fuel company was retooling for the future – a time when taxes, regulations and competition from renewable energy and other new technology alternatives are likely to thin consumers' demand for its products.

In other words, investors and the rest of the public had little way of knowing how much these changes will affect Exxon Mobil's bottom line.

Why did the company make this move now and who stands to benefit?

Shareholder pressure

Scores of investor-activists have sought to force Exxon – along with the entire global industry – to change its ways for nearly three decades. They welcomed the news regarding Exxon Mobil's upcoming climate change risk report.

But this change of course did not surprise all of them because it occurred three days before the deadline for shareholders to submit resolutions to be voted on at its 2018 annual meeting.

Exxon Mobil's latest move may prevent another episode like what happened in May, when some 62 percent of the company's shareholders – including the massive Vanguard mutual fund company – voted in favor of a resolution demanding that it publicly state how climate change is affecting its operations and bottom line.

Exxon Mobil itself indicated that shareholder pressure prompted its reversal, specifically from the New York State Common Retirement Fund, which manages roughly US$200 billion in assets on behalf of 1 million state and local government employees and retirees and their beneficiaries.

Getting accurate information

New York Attorney General Eric T. Schneiderman has also targeted the company. A lawsuit he filed in June 2017 accuses Exxon Mobil of committing fraud and inflating its stock price by keeping two sets of books.

Schneiderman alleges that one set of books, made public, is predicated on there being little risk that climate policies would interfere with the company's future ability to profit from its investments in oil and gas projects. The other alleged set of books, kept hidden, accounts for those policies leading it to earn less money, according to court filings.

Based on my research on how climate change affects corporate accounting, I also suspect that Exxon determined that disclosing its climate-related risks would help all of its shareholders and other stakeholders such as lenders, suppliers and consumers.

Ample research, including my own on the climate-related information U.S. companies voluntarily disclose, indicates that stock prices rise when outside investors have – or anticipate getting – more accurate information about plans and strategies to manage climate change risk.

Behind the curve

On top of bowing to demands from investors, Exxon Mobil needed to catch up with its competitors.

ConocoPhillips, Shell, Total, Statoil and BP already assess and report on their climate risks, along the lines of how Exxon Mobil plans to undertake this task.

In short, Exxon Mobil's executives may have realized that not disclosing risks that its peers already acknowledge would potentially hurt its stock price more than airing the information.

Had it not bowed to pressure to start disclosing its climate risks, investors could have construed that Exxon Mobil has something to hide, whether true or not.

Mounting legal woes

Exxon Mobil also faces multiple lawsuits tied to its climate-related business practices, some of which also target other oil and gas majors.

At least two are pending in California, a class-action suit is underway in Texas and the state attorney general of Massachusetts, like her counterpart in New York, is suing the oil and gas company.

It is possible that the information Exxon Mobil now plans to make public for the first time will bolster the mounting number of lawsuits it faces by plaintiffs who allege that it has harmed them as investors by withholding information, disclosing misleading climate data or revealing those details too late.

But it is also possible that the disclosure will help resolve some of the company's legal problems.

An SEC investigation

Meanwhile, the Securities and Exchange Commission is investigating how Exxon Mobil calculates its vast oil and gas reserves in light of how climate risks are changing the industry's outlook.

The SEC apparently wants to know how the company calculates the cost of complying with climate change regulations when it evaluates the potential revenue streams from its planned and ongoing projects around the globe.

These climate-related costs could also hurt its balance sheet due to the abandonment of oil and gas projects after investing billions of dollars that never yield a dime in profits. This is already happening: Exxon Mobil wrote off a $16 billion investment in Canadian tar sands in early 2017 due to the project's high cost per barrel of oil.

However, shareholders could lose money if the company ends up revealing proprietary information that aids its competitors when it discloses its climate-related risks.

I believe Exxon Mobil has resolved to disclose more of these risks because it judges that it has more to gain by reporting on its climate plans than it stands to lose by not becoming more open.

Voluntary yet consistent

In an earlier article I wrote for The Conversation with energy and sustainability expert Amy Myers Jaffe, we urged the SEC to establish a voluntary disclosure program for major oil and gas corporations. We proposed that the SEC establish a common framework for reporting on climate change risks and that it use its moral authority and enforcement powers to encourage full compliance.

This approach would bring about a steady and predictable flow of consistent and comparable information on climate change policies and outcomes. Currently, all companies are essentially on their own to disclose whatever they please whenever they feel ready to do it.

This is not always helpful for markets. When companies disclose information that investors and analysts cannot easily compare it is costly and unwieldy for them to cross-reference it.

In a recent paper, presented at the Journal of Corporate Finance conference on sustainability, Estelle Sun at Boston University, Thaddeus Neururer at the University of Akron and I show that when the cost of processing environmental information increases, analysts lose interest in dealing with it.

This means analysts issue fewer and less timely reports, to the detriment of outside investors and others, who are deprived of market prices reflecting the most up-to-date data and information.

In short, the public cannot rely only on the private sector to provide consistent and comparable information regarding the effects of businesses on climate change.

Even with Exxon Mobil's about-face, I still believe the SEC needs to create a voluntary disclosure program to correct the private sector's failure to establish a common standard for comparing climate change data as soon as possible.

Senator Tim Kaine, a Virginia Democrat, urged former Exxon Mobil CEO Rex Tillerson to discuss the company's climate track record during a confirmation hearing for the Trump administration's secretary of State.

Paul Griffin does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.
 The oil giant is bowing to pressure exerted by shareholders and the authorities as it tries to catch up with its competitors. Paul Griffin, Distinguished Professor of Management, University of California, Davis Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/80782 2017-07-28T16:34:23Z 2017-07-28T16:34:23Z Why crowds aren't always wise: Lessons from mini-flash crashes on Wall Street
Blink. About 300 milliseconds just passed, the same time required for a lightning bolt to travel 100,000 feet, a satellite to fly two miles or a stock price to swing from US$10 to $0.0001 and back.

Wait, what?

Indeed, that actually happened to the shares of the software company Qualys a few years ago. Similar mini-flash crashes involving substantial, instantaneous price moves take place about 12 times a day.

Remember the flash crash back in 2010, when hundreds of stocks temporarily went bonkers and the Dow Jones Industrial Average dove 1,000 points in a few minutes? Mini-flash crashes are the same thing yet on a smaller scale, with perhaps only one company's shares going haywire for a fraction of a second.

But they're just as consequential, both for the individual stock and in the aggregate. Such bizarre events seem to contradict our basic beliefs about the fairness of values, the sophistication of modern markets and the oft-cited wisdom of the crowd. What's going on?

To find out, we developed a mathematical model to explore how all of these ideas fit together. We initially presumed that as long as there were lots of sharp investors with broad-ranging market views, mini-flash crashes would be fairly uncommon.

Surprisingly, we observed a "too many cooks spoil the broth"-type effect instead. Even the wisest crowd, if it's large enough, can rapidly devolve into a mad herd and bring on these wild events.

Mini-flash crashes in a nutshell

Over 20,000 mini-flash crashes have been recorded since 2006, the year they really took off. Some were bigger than others, but many were pretty severe.

They're momentary, but if you get caught in one, you might incur substantial trading losses, reputational damage, fines and legal woes.

More broadly, they may erode investors' trust in markets, violate Nobel Prize-winning theories and even escalate into full-blown flash crashes like the big one from 2010. In fact, that infamous flash crash began as a disruption in a single instrument, the E-Mini S&P 500 futures contract.

Sounds pretty serious, huh?

Regulators agree and have installed measures in hopes of managing them. One rule wipes out trades that are obviously wrong (probably no one means to sell stock for hundredths of a penny). Another rule acts like a circuit breaker in your home, temporarily freezing markets when prices overheat.

Traders pitch in as well. For example, have you ever heard of a fat finger error? Maybe you wanted to sell one share at $100 but accidentally unloaded 100 shares at $1 because of a mistaken keystroke or two. Bang, the stock plunges 99 percent instantly. Financial firms maintain internal checks such as operational risk controls to avoid such havoc.

Yet, despite all this, mini-flash crashes keep happening, and some worry the problem is getting worse.

An army of simulated investors

To understand why the mini-flash crash problem just won't go away, we designed a model that takes all we know about investing and subjected it to mathematical analysis and computer simulations so we could observe whether a group of traders armed with various strategies could steer clear of mini-flash crashes.

For instance, in developing our model, we wanted to ensure that our "investors" devised their strategies as if they were actually human. In addition to classic questions like "Where are prices going?," today's traders ponder much more sophisticated issues before buying or selling. They might ask, "How confident am I in this answer? How often should I check back to make sure it's still right? Am I worried about betting the bank? Could my trades themselves impact the future and change whether I'm ultimately right?"

We plugged these considerations into mathematical formulas. Each of our investors was assigned specific parameters (like the models Wall Street traders use), which served as guides for how and when they would trade given various market conditions.

In other words, we tried to make our simulated investors as complicated as real ones, with a healthy mix of characteristics.

Here's what we found.

Our investors initially operated a calm and stable market, free of crashes. The supposed wisdom of the crowd prevailed, as long as certain conditions held true:

All investors were confident in their opinions about future markets.

All investors fully reworked their models often. That is, models (like the ones described above) can become corrupted over time and need to be readjusted. A failure of investors to readjust their models likely contributed to the dot-com bubble or the housing bubble, when we watched prices go up and up and figured that the good times would last forever. If only we'd taken a step back to check ourselves, right?

All investors were hesitant to take big risks.

There weren't too many investors. It's not that we found a specific number here; rather we discovered that the crowd sometimes got so large that the extra stability provided by their varied opinions got outweighed by their tendency to stampede towards a mini-flash crash at the slightest tremor.

But in a fast-moving market, these conditions didn't always persevere. Even though investors were continually revising their views, they weren't doing so fast enough to avoid being caught up in a herd mentality and selling off a stock along with everyone else in response to a lone investor's opinion.

Say some investor got spooked and started selling. This drove prices down a little, which may have worried a few others. They started selling too, causing prices to drop even further. Pretty soon, the whole market was unloading, and prices hit rock bottom.

If our investors weren't sure about their views, this all happened much faster. They'd change their beliefs on a dime. We saw the same thing when they weren't afraid of taking risks or didn't step back enough to reassess their strategies.

What was most surprising for us, as previous believers in the strength of wise crowds, was that increased population size alone could be destabilizing. In fact, the number of investors active in our simulations was one of the greatest determinants of whether a mini-flash crash would ensue.

 <img alt="" src="https://images.theconversation.com/files/179646/original/file-20170725-30134-6wzeq5.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/179646/original/file-20170725-30134-6wzeq5.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=383&fit=crop&dpr=1 600w, https://images.theconversation.com/files/179646/original/file-20170725-30134-6wzeq5.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=383&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/179646/original/file-20170725-30134-6wzeq5.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=383&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/179646/original/file-20170725-30134-6wzeq5.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=482&fit=crop&dpr=1 754w, https://images.theconversation.com/files/179646/original/file-20170725-30134-6wzeq5.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=482&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/179646/original/file-20170725-30134-6wzeq5.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=482&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
 'Tulipmania' in the 17th century is often considered the first market bubble. Here, monkeys portray Dutch speculators buying and selling rare tulip bulbs. Brueghel the Younger

History repeats

Our research suggests it may be impossible to completely stop mini-flash crashes, as recent high-profile plunges in the prices of gold and silver demonstrate. Many market observers claim that such instantaneous tumbles are the "new normal."

Perhaps it's not so startling. After all, back in 1841, Scottish journalist Charles Mackay had already brought the recurring nature of bubbles and crashes to the public's attention in "Memoirs of Extraordinary Popular Delusions and the Madness of Crowds." To some extent, it's no wonder that they should be frequent and rapid these days, given the speed of today's markets.

That tulip trading persisted late into the night at Dutch taverns (after many rounds) has been cited as a potential cause of "Tulipmania," an event in the 1600s where a single bulb is rumored to have cost as much as 50 live pigs. While we're a long way from such things, the line between a wise crowd offering stability and a mad one creating chaos is clearly as thin as ever.

Alexander Munk receives funding from a University of Michigan Rackham Predoctoral Fellowship.

Erhan Bayraktar receives funding from the National Science Foundation.
 New research suggests mini-crashes, in which the price of a single stock or commodity temporarily goes haywire, may be unstoppable. Alexander Munk, Ph.D. Candidate in Mathematics, University of Michigan Erhan Bayraktar, Professor of Mathematics, University of Michigan Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/73417 2017-05-03T01:14:23Z 2017-05-03T01:14:23Z Why Dodd-Frank – or its repeal – won't save us from the next crippling Wall Street crash
Republicans appear poised to roll back Wall Street regulations passed after the 2008 financial crisis. Democrats argue doing so would be a "monumental mistake."

It's been framed as a typical fight over regulation. Democrats want more to protect taxpayers and investors from the next crisis; Republicans want less because it stifles economic growth.

So who's right?

Based on our combined 35 years of experience with securities markets and the research we've done for our new book, "When the Levees Break: Re-visioning Regulation of the Securities Markets," we think both sides are wrong. The issue isn't about more or less regulation but about the need for a streamlined system that supports 21st-century investing.

If we had our way, the whole system of financial regulation would be burned to the ground and replaced with something entirely different.

Of bonds and banks

Before we go any further, let's clarify what we're talking about. When we think of financial markets, we tend to jumble securities markets like stocks, bonds and commodities with conventional bank lending such as checking accounts and lines of credit.

The Dodd-Frank Act, for example, was ostensibly focused on regulation of securities markets, but the rules that got the most attention were those that affect the "too big to fail" banks. That those banks straddled both worlds made the market crash life-threatening.

But securities trading, and in particularly derivatives, were at the root of the 2008 financial crisis. For our purposes, when we talk about financial regulation, our focus is on the securities markets.

How did we get here?

The financial markets meltdown in the fall of 2008 devastated our economy, but it still pales in comparison with the stock market rout that preceded the Great Depression in October 1929. The Dow Jones Industrial Average fell 23 percent from Oct. 28 to Oct. 29 that year, compared with a two-day slide of at most half that throughout the 2008 crisis.

After the 1929 crash, lawmakers reacted by passing laws aimed at ensuring investor protection. Two groundbreaking pieces of legislation, passed in 1933 and 1934, required companies to submit quarterly and annual reports and established the Securities and Exchange Commission. These laws form the cornerstone of modern securities markets regulation.

But they were only the beginning. As markets expanded and changed, Congress continued to craft new laws that added more agencies to oversee Wall Street activities. As a result, we have more than two dozen agencies, self-regulatory organizations and exchanges (including the Commodities & Futures Trading Commission, the Treasury and the Departments of Labor and Justice), not to mention state securities agencies, all with overlapping regulatory jurisdictions.

Moreover, the laws have been reactionary – rather than visionary – resulting in competing concerns and duplicative audit and enforcement procedures. Not surprisingly, there is largely no coordination or communication between them.

Meanwhile, the SEC – as primary regulator – is bogged down with too many directives, many of which are under- or unfunded. For decades, whenever Congress passed a bill to "regulate" big changes in the markets – from market crashes to "advancements" such as mutual funds and investment advisors – the SEC has been required to add oversight of these new practices to their existing responsibilities. Dodd-Frank, for example, expanded the SEC's role and called for additional internal audits of existing practices but – like past market-related legislation – failed to include funding for those activities.

Amid all the regulation, investor protection seems to have gotten lost.

Enter Dodd-Frank

The severity of the 2008 crash and its economic impact (including investment company failures and unprecedented government bailouts) goaded Congress into action.

In 2010 Democratic lawmakers passed the Dodd-Frank Act, the most extensive revision of securities regulation since the 1930s, with the hope that more regulation would prevent another crisis.

Republicans have argued for its repeal ever since, claiming the law and the regulations designed to implement it (many of which are behind schedule) inhibit prosperity.

Both parties are missing the point. The current system of financial regulation is built on how stocks were traded in the 1930s – when computers and algorithmic trading had yet to be a glimmer in a quant's eye. To paraphrase the Oldsmobile commercial, it's not your father's stock market anymore.

My, how markets have changed

Financial markets have undergone a fundamental transformation over the past 80 years.

First of all, there are the investors themselves. The mom and pop investor that the SEC was created to protect has by and large been replaced by institutional investors, including quantitative analysts or "quants" that use complex algorithmic formulas to predict the best trading strategies. In fact, algorithmic trading makes up the majority of volume in today's markets.

Then there's the issue of disclosure. Since the dawn of federal securities regulation, lawmakers and regulators have relied on disclosure to protect investors. Public companies are required to disclose volumes of information, from financial information to dealings with Iran and even their Code of Ethics. As a result, a company can spend over a million dollars each year complying with disclosure regulations that few people actually read. Yet every time there's a new disaster, Congress piles on the disclosure requirements, as happened with Dodd-Frank.

But for all the hundreds of pages of disclosure, at no time in the past 80 years has there been a mandate to review the actual securities products issued by public companies and investment banks. There are no "safety" standards for stocks, like there are for cars or toasters. The products that brought down the house in 2008 – mortgage-backed securities and products derived from them – continue to be offered to the public, including new ones backed by credit card debt and student loans.

Finally, the SEC and other regulators are unequipped to keep up with the breathtaking changes in technology, let alone anticipate potential advances and challenges. To understand why, one must only consider the breadth of organizations that have fallen victim to hackers, from Target and Yahoo to the Veterans Administration, and the Federal Reserve itself.

Unfortunately, however, Congress does not fund the SEC in a way that would allow it to pay for the skills or systems it needs to keep up with technological and other market advances. Following Dodd-Frank, for example, the SEC's budget was actually reduced, even as its responsibilities multiplied.

In sum, what we have is a regulatory system that fails in its mission to protect investors. The structure used to oversee current investment practices, corporate disclosures, product development and technological advances is based on the market failures of 1929. It's a bit like trying to surf the internet using a typewriter.

Preparing for the next crash

The next "big" crash will likely be bigger than the last one. So how do we prepare for it?

Dodd-Frank is largely an extension of the patchwork structure and won't protect us in the future. Yet the Republican answer, to repeal it and let markets self-regulate, won't stop the proliferation of products that nearly brought the house down in 2008. After the next crash, institutions will not be too big to fail, they'll be too big to save.

The answer, in our view, is a complete rethinking of how we regulate investing. As the White House moves to dismantle Dodd-Frank, this is the perfect time to do exactly that. Let's get rid of what doesn't work – which is pretty much everything – and replace it with a system that does.

What we envision is a contemporary, 21st-century holistic structure built on proactive, thoughtful and streamlined laws that takes into account markets that are technology-driven and move in nanoseconds.

Think of it this way: Our regulatory structure is like the dike that keeps springing leaks – the makeshift plugs we've used are so ineffective that the dike isn't leaking – it's crumbling. We need to build a new dike, using all available technology, before the next tidal wave hits.

We don't claim to have all the answers. But we want to get the conversation started. We invite you to join in.

The authors do not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.
 Instead, we need to burn the entire system of financial regulation to the ground and replace it with something that supports investing the way it's done today. Jena Martin, Professor of Law, West Virginia University Karen Kunz, Associate Professor of Public Administration, West Virginia University Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/73570 2017-03-06T02:15:36Z 2017-03-06T02:15:36Z Why Wall Street is like a used car lot
In 1792, before there was the internet, the telephone or even the telegraph, securities trading began on Wall Street.

A small group of dealers, who met under a buttonwood tree on Wall Street, agreed to trade only with each other and established a minimum fee for their service. At that time, most trading involved the buying and selling of government bonds.

A quarter-century later, on March 8, 1817, securities dealers changed their rules a bit, moved into bigger quarters on Wall Street and officially created the New York Stock and Exchange Board. This was later shortened to the New York Stock Exchange (NYSE). Today it is the largest securities exchange in the world, trading around US$200 billion each day, mainly stock certificates or ownership shares in private firms. The value of all the companies on the NYSE, about $16 trillion, comes close to the value of what the U.S. economy produces in new goods and services each year.

As the NYSE marks this bicentennial milestone, it is worth asking, what do stock markets actually do?

This question is particularly apt right now as U.S. shares set new records on a regular basis, with some calling the roughly 15 percent gain in the Standard & Poor's 500 since Election Day a "Trump bump" created by optimism about his plans, while others chalk it up to "irrational exuberance," to use a famous phrase of Alan Greenspan, former chair of the Federal Reserve.

Based on my many years of experience teaching and writing about financial markets and frauds, the best way to understand what's really happening on Wall Street – and puncture its mystique – is to imagine a used car dealership.

The aura of the NYSE

The NYSE gets its aura from the fact that so much money is involved. Even for those with a relatively small stock portfolio, a change in stock prices of 2 to 3 percent can result in gains or losses amounting to thousands of dollars.

Also, people are attracted by simple numbers, especially ones that fluctuate and get reported regularly with much fanfare, such as gasoline and stock prices.

More importantly, the NYSE helps finance new investment. When a large company wants to expand, it prints up new shares of stock and then tries to sell them. If successful, the company gets money (fresh capital) that enables it to expand its operations. This is what Snap Inc. – maker of the Snapchat app – did on March 2, when it raised $3.4 billion in its initial public offering.

However, this is not what most stock trading is about. Virtually all the activity on the NYSE involves someone who already owns part of a company (represented by stock certificates) selling it to somebody else.

In this way it is very much like a used car dealership. Used car dealers buy old cars and resell them. Similarly, stock markets are places where someone sells her part ownership in a company to a dealer, who then finds someone else to buy it.

That is it. Ownership of a company changes hands, with the exchange serving as the middleman or used car dealer. Other than at the dealership, which makes some money on the trade, no jobs get created and no production takes place.

Of liquidity and lemons

From this perspective, stock exchanges like the NYSE have some positives as well as some negatives.

On the positive side, markets let us sell things quickly. When I want to get rid of my car, it is more convenient to have a used car dealer serve as an intermediary than for me to sell it myself. In addition, because it is easy to sell my car every few years, I may purchase a new car more frequently, which increases consumer spending and strengthens the economy. Similarly, it is easier for companies to raise money for new investment when the buyer knows he can resell the shares easily. In Wall Street parlance, this is called "liquidity."

But there are also negatives. First, as all used car buyers know, it is easy to end up with a lemon. Most people don't know the specifics of a particular car or a specific company. In both cases, there are incentives for sellers – the car dealers or investment advisers – to hide any flaws in what they want to sell, thereby deceiving buyers. Commissions for making sales is more important for these people than helping a buyer make a good decision.

The history of financial markets is also a history of fraud, from the South Sea Bubble of the early 18th century to Bernie Madoff's Ponzi scheme in the 2000s.

Second, financial markets (unlike used car markets) tend to generate speculative excess since people buy assets to make financial gains rather than consume what they buy. Economist John Maynard Keynes compared stock markets with a rather strange beauty contest whose objective was to pick (from a large group of faces) not the most beautiful one, but the one that others would pick as the most beautiful.

Keynes got it exactly right. On stock exchanges, success means doing what other people are doing, rather than buying the shares of companies that are really the best. Such herd optimism can last only so long, however. The stock market crash of October 1929 saw the Dow Jones Industrial Average fall 25 percent in two days, followed by further sharp declines. By May 1932, the market had lost 80 percent of its peak value. The Great Depression that followed showed that when bubbles burst, the damage to the economy can be very long and very large.

Similarly, the 2008-2009 stock market plunge of more than 40 percent resulted in the Great Recession.

Finally, because people pay attention to readily available numbers and are attracted to wealth, rising stock prices become more important than producing a quality product efficiently. Owners of company stock care about recent performance and the quarterly results (sales and profits) of individual firms. They care less about the long-term investment plans of the business and whether quality is improving (something that leads to reputational gains and more profits in the future). As a result, company CEOs come to care more about the short-run performance of the firm and less about the long-term performance.

This is why we constantly get scandals such as car companies installing exhaust systems that are polluting but can beat inspection tests and financial firms that sign customers up for accounts that they did not ask for and then charging them for this.

Quarterly financial results will look good and keep Wall Street happy. But unhappy customers will eventually abandon the business, leading to falling profits.

Unraveling the 'Trump bump'

This brings us back to the so-called Trump bump.

Investors dislike uncertainty. Upcoming elections add uncertainty, which ends with the election results no matter the outcome. This is one reason stocks tend to perform well in the year after a presidential election.

Stock prices rose 23 percent and 30 percent, respectively, in each of the years after Barack Obama won the election. They increased 7 percent and 31 percent following Bill Clinton's victories in 1992 and 1996.

Economic factors are not irrelevant, though. Stocks did poorly the year after Ronald Reagan's first election due to economic circumstances (ditto for George W. Bush) but rose 26 percent the year after "The Gipper" was reelected in 1984.

While we are likely to see a similar post-election rise in stock prices this year thanks to reduced uncertainty, there are other factors behind the recent rally. President Trump has promised deregulation and corporate tax cuts, which will increase corporate profits and make their shares more valuable.

But his post-election honeymoon may not last long. One reason is that these policies could reduce middle-class incomes by limiting competition, reducing government spending and making another financial crisis more likely. And that's bad news for companies, their stocks and the economy because consumers won't be able to afford as many of their goods and services.

So just as the stock market feeds off optimism, when reality falls short of expectations, despair can create a downward spiral. The danger we face is that this "Trump bump" could be followed by a "Trump dump" if investors realize they've purchased a portfolio full of lemons.

Steven Pressman does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.
 As the New York Stock Exchange marks 200 years since its official formation, investors are wondering whether the surging stock market is a 'Trump bump' or more like a lemon. Steven Pressman, Professor of Economics, Colorado State University Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/72289 2017-02-03T13:59:46Z 2017-02-03T13:59:46Z Has Donald Trump really inspired the US stock market to new heights?
In the middle of the pomp of a presidential inauguration and the fervour of the mass protests that followed you might have heard the cheering of financial traders as the US benchmark stock index, the Dow Jones Industrial Average surged past 20,000 points for the first time. This symbolic moment signals a hope among investors that Donald Trump's pro-business policies will fuel the US economy. Other key markets, the S&P 500 and the tech-heavy Nasdaq also saw significant gains.

Since the arrival of Trump in the White House, both household and business sentiment indicators have risen. Bloomberg analysis of small businesses and consumer confidence reports a substantial boost to optimism. And Trump's pledges on deregulation and tax reforms have been perceived as a step in the right direction by business. Both have been cheered by corporate leaders, including Randall Stephenson, the CEO of telecoms giant AT&T, and JP Morgan boss Jamie Dimon.

The "Make America Great Again" slogan seemed to be resonating with the stock market fraternity; "America First" rhetoric pushing investor sentiment towards euphoric levels.

 <img alt="" src="https://images.theconversation.com/files/155391/original/image-20170202-1641-1eao2vw.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/155391/original/image-20170202-1641-1eao2vw.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=400&fit=crop&dpr=1 600w, https://images.theconversation.com/files/155391/original/image-20170202-1641-1eao2vw.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=400&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/155391/original/image-20170202-1641-1eao2vw.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=400&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/155391/original/image-20170202-1641-1eao2vw.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=503&fit=crop&dpr=1 754w, https://images.theconversation.com/files/155391/original/image-20170202-1641-1eao2vw.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=503&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/155391/original/image-20170202-1641-1eao2vw.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=503&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
 Cap and trade. Gage Skidmore/Flickr, CC BY-SA

Obstacles, of course

However, the excitement that has greeted a new, "pro-business" administration has many hurdles to clear. The first test comes in the form of Trump's tough stance on immigration and the imposition of travel restrictions on seven, mainly Muslim countries. There has been widespread condemnation, from Canada, Germany, France, the UK and from within the US itself. US companies, notably auto companies which boast large numbers consumers and staff of Arab origin, have largely stayed silent on the matter. Car makers during the height of the 20th century industrial boom, especially Ford, hired workers from Yemen and other parts of the Middle-East. This gave rise to a new Arab community around Ford's factory in Highland Park, Michigan that grew alongside the booming sector.

But some have been noisy in opposition, particularly tech firms. The CEOs of Google and Microsoft have shared their dismay over the policy, while Amazon chief Jeff Bezos – concerned about the impact on staff around the world – is supported Washington state's legal action against the ruling.

 <img alt="" src="https://images.theconversation.com/files/155393/original/image-20170202-1673-eak3zq.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/155393/original/image-20170202-1673-eak3zq.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=466&fit=crop&dpr=1 600w, https://images.theconversation.com/files/155393/original/image-20170202-1673-eak3zq.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=466&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/155393/original/image-20170202-1673-eak3zq.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=466&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/155393/original/image-20170202-1673-eak3zq.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=585&fit=crop&dpr=1 754w, https://images.theconversation.com/files/155393/original/image-20170202-1673-eak3zq.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=585&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/155393/original/image-20170202-1673-eak3zq.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=585&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
 US stocks over the last month. Google Finance

The impact of all this is uncertain, of course. But it is hard not to conclude that the outcry over Trump's immigration position, and the challenge from the tech industry, has had an impact on market sentiment. The Dow Jones Industrial Average has since fallen back below the 20,000 level and now sits at about 19,900 points. The political wrangle that followed, including the firing of acting Attorney General Sally Yates over the immigration order, also caused jitters in the market.

But let us assume for now that the Trump administration's "business friendly" rhetoric helps to smooth over the shock: Wall Street won't have to wait long before investor resolve is tested again.

Trade offs

This will likely come from Trump's position on global trade. The president has been particularly contemptuous of efforts by China and Japan to weaken their currencies to obtain an advantage over of the US. He directly criticised the Bank of Japan for using aggressive monetary policy to devalue the Yen with the intention of boosting Japanese exports and substantially reducing the cost the imports. The difficulty for stock market traders lies in assessing the veracity and significance of the Trump's interventionist approach to monetary policy, beyond its political propaganda. The US dollar saw a decline against the Yen before recovering its ground. This indicates some nervousness perhaps, but most of all a lack of certainty.

There is more confidence over Trump's oft-repeated commitment to reduce the budget and trade deficits, which stand at US$552 billion and US$45.2 billion, respectively. He may yet take a leaf out of Japan and China's monetary policy book. Devaluing the dollar, equal to the devaluation of the Yen, to encourage US exports would certainly address the trade deficit.

An interventionist approach is also on the cards. Trump has vowed, since being elected, to introduce import tariffs to curb what he views as exploitative imports from countries like China and Japan, which are destroying the US balance of payments. Trump's tough rhetoric gives US trading partners cause for concern. Haruhiko Kuroda, governor of the Bank of Japan, warned that Trump's protectionist measures could have a detrimental impact on international trade, which might lead to global economic deceleration. Whether the US can "win" in that environment is difficult to guess.

The Trump administration's first week ebbed and flowed on investor confidence, public outcry and trade rhetoric. The Dow stock index record was a bright spot, but many testing times lie ahead. Hopes for growth-lifting stimulus, deregulation and tax reforms will have to battle with harsh realities of a divisive immigration policy and the potential for a contentious and unpredictable global trade war. Wall Street remains bullish – an avowedly business-friendly president is not to be sniffed at after all – but fingers will be hovering over the sell button if the Trump mantra starts to wobble.

Dr Hassaan Khan is the Deputy Head for Financial Research and Enterprise at Anglia Ruskin University.
 Investors have given Donald Trump the thumbs up, so far, but trader sentiment can't be guaranteed. Hassaan Khan, Deputy Head of Department (Accounting & Finance), Anglia Ruskin University Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/70449 2017-01-25T14:44:09Z 2017-01-25T14:44:09Z Why Wall Street's Dow 20,000 is totally meaningless
The Dow Jones Industrial Average just broke 20,000 for the first time.

Traders and investors cheered this historic high of the world's most famous stock market index, which is composed of 30 of the biggest and best-performing American companies and is frequently used as a barometer of the strength of the economy.

Even though it took a little while, after several close calls in recent weeks, it's hardly a surprise that the Dow hit this particular milestone. It and other major stock indexes like the Standard & Poor's 500 have two key features that ensure that they will continually rise and break new zero-filled records: They ignore inflation and are heavily curated.

No inflation adjustment

The first reason why stock market indexes, like the Dow, rise over long periods of time is that the indexes are not adjusted for inflation.

Inflation is when overall prices increase. It is a modern occurrence in most major countries. When there's inflation, everything costs more as time passes, including the price of shares of stock.

The Dow Jones index is calculated by adding up the non-adjusted stock prices of all 30 members and dividing by something known as the "Dow divisor," which is continually adjusted to account for stock splits, spin offs and other changes. This divisor ensures historical continuity.

The importance of the long-term inflation in driving stock market indexes higher is seen by understanding the "rule of 70." This rule shows how long it takes for the average price in the economy to double. For example, if something costs US$10 today, the rule of 70 shows how many years it will take for the price to reach $20.
 To determine the number of years, divide 70 by the inflation rate stripped of its percentage sign. Details on the rule of 70 are discussed in chapter 12 of my textbook.

Since the turn of the 21st century, U.S. inflation has increased prices by roughly 2.2 percent per year. If prices continue to rise at this rate, then the typical price of most things in the U.S. will double roughly every 32 years (70 divided by 2.2). So if inflation were to persist at this rate, this means about three decades from now the Dow will hit 40,000, even if businesses sell the exact same number of cars, phones, movies, meals and all the other things available in the economy.

Underperformers are eliminated

The second reason why the Dow inevitably rises over long periods of time is that under performing companies are periodically removed from the index and replaced by companies that are performing better.

Replacing under performing companies that have a falling stock price, with companies that have a rising stock price ensures the index continues to climb over the long term.

Charles Dow, one of the founders of the Wall Street Journal newspaper, started the Dow Jones Industrial Average in May of 1886. His intention 120 years ago was not to create an index that regularly hit new highs. Instead, the goal was to give readers a single number to give them a quick understanding of how the stocks of the most important companies were faring.

Nevertheless, because the list of companies in the Dow has changed many times to eliminate under performing stocks, it is essentially designed, even if by accident, to climb ever higher.

The Dow for decades has been comprised of 30 stocks. Nevertheless, over its 120 year existence there have been 133 different companies on the list. The editors of the Wall Street Journal choose which companies are in the index and once a year, on average, add a new company to the list and drop an old one.

Since 2010, the Dow has included five new companies; Apple, Goldman Sachs, Nike, United Healthcare and Visa. To keep the list fixed at 30, five companies have been dropped: Alcoa, AT&T, Bank of America, Kraft Foods and Hewlett-Packard.

General Electric, or GE, is the only company that was both on the original 1886 list and included in the index today. Nevertheless, even this major company founded by Thomas Edison has not been on the list continuously. It was dropped in 1901 and then reinstated at the end of 1907.

Many famous companies in America were on the Dow and then were dropped before going bankrupt or drastically shrinking in size. Eastman Kodak was dropped in 2004, while Bethlehem Steel was removed in 1997, both only a few years before going bankrupt. The editors knocked off Sears Roebuck in 1999 and F.W. Woolworth in 1997 as people shifted away from buying items at department stores and five and dimes.

The periodic replacement of companies means the Dow operates like an actively managed mutual fund, in which humans pick companies that are expected to do well in the future. The Dow needs periodic human intervention. Without it, the list would slowly atrophy as companies die off or become less relevant to the overall economy.

Dow 40,000, here we come

In sum, the presence of inflation in the U.S. and the continued efforts of editors at the Wall Street Journal to replace lagging companies in the index with companies that have high-flying prospects and stock prices will always result in headlines every so often that trumpet "turn-of-the-odometer" milestones like 25,000 and 30,000.

The question is not whether the Dow will reach 40,000. The only question is when?

Jay L. Zagorsky does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.
 The world's most famous stock index just broke 20,000 for the first time. Here's why it doesn't really matter. Jay L. Zagorsky, Economist and Research Scientist, The Ohio State University Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/70776 2017-01-11T02:07:51Z 2017-01-11T02:07:51Z Will the 'Trump rally' continue through 2017?
So far, investors appear to be giving Donald Trump their vote of confidence.

After his election as the 45th president of the United States, the U.S. Dollar Index rallied around 4 percent through the end of the year, while the Dow Jones Industrial Average approached 20,000 for the first time in its history and the Standard & Poor's 500 was up just under 5 percent.

So now that investors have finished their usual year-end review of where to put their money, one question is on everyone's mind: Will the so-called Trump rally continue in 2017?

In early November, I wrote an article based on my study showing that how stocks reacted in the first few days after a president's victory would likely determine their performance for the rest of 2016 – which turned out to be true in Trump's case.

In a similar vein, a separate study I published in 2009 demonstrated that how a stock market performs in the January a president takes office could portend its fortunes for the remainder of the year.

So will that also turn out to be true for Trump?

'As January goes'

In that study, which I called "The 'Other' January Effect and the Presidential Election Cycle," I combined two lines of research.

First, going at least as far back as the 1940s, the so-called January effect is a well-known bias in individual stock behavior in which stocks that lose value at the end of the year tend to reverse those losses in January.

The other January effect, which I use in my study, refers to evidence published in 2005 suggesting that January's returns hold predictive power for the remainder of the year.

More specifically, this effect claims that when stocks go up in January, they tend to continue to climb for the rest of the year, and vice versa – regardless of the impact of other usual drivers of stock market returns. On Wall Street, this effect is often dubbed: "As January goes, so goes the year." For the rest of the article, for simplicity's sake, I'll call this the January effect.

Second, I combined this January effect with the four-year presidential election cycle (PEC) to see how it influenced January's predictive abilities. The PEC refers to a cycle in which U.S. stock market returns during the last two years of a president's term tend to be significantly higher than gains during the first two years. This cycle is especially true for the third year of a president's term, which has almost always been positive.

For my study, I wanted to see if the timing of the presidential cycle (first year, second year, etc.) affected January's predictive abilities. I studied monthly returns (without dividends) of the S&P 500 over the 67-year period from 1940 through 2006.

January's predictive power

Overall, my results were consistent with the paper noted above demonstrating that positive returns in January typically portended gains during the other 11 months of the year, as well as the opposite.

They further showed, however, that January's predictive power is most convincing during the president's first and fourth years in office. Since, at the moment, we care most about the first year of a president's term, I'll focus on those results.

Over my sample period of basically 17 election cycles, I found that during the president's first year in office, average returns for the 11 months following a positive January were 12.29 percent, while a negative January led to average losses of 7.91 percent over the remainder of the year. That's a difference of more than 20 percentage points – or over US$200,000 on a $1 million investment.

Furthermore, I found that a positive or negative January predicted returns for the remainder of the year almost 90 percent of the time, suggesting a very strong correlation.

Recent results have been split

Since my study was published, there have been two more elections, one of which ran contrary to the January effect, while the other confirmed it.

After President Barack Obama won the 2008 election, the S&P 500 lost 8.6 percent during his inaugural month of January. But the market rallied for the remainder of the year by about 35 percent.

Conversely, after his reelection in 2012, stocks returned around 5 percent in January 2013 and, consistent with the other January effect, the market climbed another 23 percent over the remainder of the year.

What's behind this?

So what's driving the effect?

Exactly what drives this effect is a topic of debate. For example, I tested whether it may be driven by monetary policy, which did not seem to be the case.

A common argument for the PEC is that it reflects investor views of fiscal policy, which is why returns during the second two years of the cycle tend to be higher than the first two. Yet my most significant results were for the first and fourth years.

Nonetheless, while I did not specifically test for fiscal policy influences, it seems valid since my results showed that January's effect appears to be the most reliable during the president's incoming year in office. The effect wasn't nearly as pronounced during the other three years.

So far, that seems to be the case at the moment as the "Trump rally" appears to be a response to anticipated fiscal policy.

What to expect in 2017

Of course, there is never complete certainty in the markets, especially with an unavoidably small sample size like 17 election cycles. Still, the results of my study provide compelling evidence that, particularly in the president's first year in office, January's returns appear to capture information that is valuable for anticipating returns for the remainder of the year.

As of Jan. 10, the S&P 500 was up about 1.5 percent for the year and near its record high of 2,282, while the Dow continued to flirt with that magical 20,000 number.

While January's full-month returns are not yet known, history strongly suggests that investors would be wise to closely monitor the S&P 500. If January 2017 remains positive for U.S. stocks, returns for the remainder of 2017 may very likely also be positive. The opposite can also be expected.

So for investors looking ahead in 2017, as January goes, perhaps so will the remainder of 2017.

Ray Sturm does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.
 A common Wall Street adage claims: 'As January goes, so goes the year.' What does that mean for investors as stocks look set to end President-elect Trump's first month in office higher? Ray Sturm, Associate Lecturer of Finance, University of Central Florida Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/57998 2016-04-21T20:41:02Z 2016-04-21T20:41:02Z Why the rand punches above the weight of South Africa's economy

The South African rand is the 18th most traded currency in the world.  Reuters/Siphiwe Sibeko

Is the size of the South African economy out of sync with the ranking of the rand as the 18th most traded currency in the world?

The South African economy is the 33rd biggest in the world, with a gross domestic product of US$350 billion in 2014. But its currency, the South African rand (ZAR), is ranked 18th when the percentage shares of the average daily turnover of the global foreign exchange market are considered.

The South African rand has recently experienced an unprecedented level of volatility – more so than most, if not all, emerging-market currencies. But a greater part of the pain has been self-inflicted.

The low economic growth outcomes in the recent past, as well as the poor growth outlook and domestic political risk issues have all contributed to putting the local currency on the back foot. An example of this played out in South Africa in December 2015, when the country's finance minister was abruptly fired and replaced with an unknown backbencher. Investors lost confidence in the running of the economy, with terrible consequences for the rand, which reached a new low of more than R16/US$.

Size of economy vs currency trades

But this recent volatility can't be blamed on the fact that the rand punches above its weight in the foreign exchange market. Other reasons account for this.

South Africa is not alone. There are many other small economies in the world whose currencies have bigger shares in the global foreign exchange market.

For example, the Swiss franc is the sixth most important foreign exchange market in the world, but the country is ranked as the 20th biggest economy. New Zealand is ranked as the 53rd biggest economy, but the New Zealand dollar is the tenth biggest foreign exchange market.

On the reverse side, there are a number of countries with big economies whose currencies are traded very little. This is because they don't have a well-developed financial market. South Africa's BRICS partners Brazil and India have much bigger economies than South Africa, but their foreign exchange markets are smaller.

The US and Japan, the first and third biggest economies in the world, also have well-developed financial markets. It is therefore no wonder that the US dollar and the Japanese yen are the first and third most traded currencies in the world.

The Chinese yuan occupies ninth position in the ranking of traded currencies, even though it is the second biggest economy in the world. This is due to the fact that its financial markets are relatively underdeveloped.

This shows that the size of an economy has no role in the tradeability of its currency.

ZAR foreign exchange market size

The ZAR foreign exchange market, like that of any other tradeable asset, is underpinned by demand and supply. These determine its market size.

There are a number of critical players on both sides. They include:

Individuals and institutions that plan to buy South African assets – real and financial. Real assets include residential and non-residential properties. Financial assets are made up of bonds, stocks, derivatives and other financial instruments. On the supply side are those who plan to sell these assets.

The export demand of South African goods and services is also a major source of demand for the currency. In the same way, the supply side is driven by exporters of South African goods and services

Currency speculators. Speculators of the currency buy and sell and sometimes hold the currency for a while to make a return from favourable fluctuations in its value. Speculators are also a source of supply.

Who is doing the buying and selling? A host of players are active in the foreign exchange market of the rand. These include: commercial and investment banks, central banks, securities houses, asset and fund managers, companies and institutional investors such as pension funds.

Benefits and risks

The interest in South Africa's currency in the global foreign exchange market is a reflection of how the domestic economy is plugged into the world economy, particularly the developed world. This needs to be cherished.

This connectivity is facilitated by a financial system that is well regulated. In fact, it outperforms a great many other developed countries. For example, for four consecutive years the country was ranked number one in the world when it comes to the regulation of securities exchanges.

The benefit of being connected to the international financial market is that South Africa's market is exposed to a larger number of participants. This contributes immensely to the liquidity of domestic real asset and financial asset markets.

Classical economic theory suggests that high liquidity results in trades being priced correctly. This doesn't happen in an illiquid market with a small number of buyers and sellers.

The danger posed by speculators

Speculators pose the biggest risk to a currency. Because the rand is traded in all major foreign exchange markets such as the UK, US, Japan, Singapore and Hong Kong, speculators can present a danger to its pricing.

But the risk of an attack by speculators is minimal if the South African Reserve Bank is seen to be pursuing a sensible exchange rate policy. For instance, if the South African Reserve Bank decides to intervene in the rand foreign exchange market with the intention of managing the currency's exchange rate it may open up the currency for speculative attacks.

A classic example is the famous "Black Wednesday" episode, when speculators broke the British pound on September 16 1992. The British government got its fingers badly burnt in an attempt to support the pound. One speculator, George Soros, is reported to have walked away with $1 billion in a single day from betting against the Bank of England.

Its lesson shouldn't be lost on anyone.

In fact, the hands of the South African Reserve Bank are tied as far as the rand's foreign exchange rate is concerned. Even if it wanted to, it couldn't intervene in any meaningful way to influence the direction of the currency's foreign exchange rate. This is because it doesn't have the resources: the foreign exchange market is massive relative to the foreign exchange reserves of the country.

Just look at the numbers. The bank's gross official gold and foreign exchange reserves are estimated at $47 billion. Given that the value of trade in the rand alone is more than $60 billion in a typical day, it would be foolhardy to imagine that the country's foreign exchange reserves can be used to prop up the currency's exchange rate.

That's not to say that nothing can be done. Undue volatility can be managed. The government and its National Treasury, which oversees the country's economy, have a role to play. They can make sure that economic policies are sound and stable, and that investor confidence in the country is maintained. The government can also make sure that the rule of law is upheld.

Matthew Kofi Ocran receives funding from NRF.
 How is it possible that an African country whose currency is one of the top 20 most traded in the world only has the 33rd biggest economy? Matthew Kofi Ocran, Professor of Economics, University of the Western Cape Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/53502 2016-01-25T19:21:02Z 2016-01-25T19:21:02Z Why so bearish? How hidden bias is sinking global stocks

The negative sentiment surrounding the stock market is a self-fulfilling prophecy.  From www.shutterstock.com

It's been a shaky start to 2016 for global stock markets, with substantial falls across all international markets, followed by some weak rallies.

The overall decline has been partly blamed on the price of crude oil, which is hovering around US $30 a barrel down from $100 over a year ago, along with market fears on the overall health of the Chinese economy.

The headlines tell us markets are sinking in the sea of oil. A measure of fear in the stock market, the widely quoted Chicago Board Options Exchange volatility index, is also closely tracking the oil price, adding to the gloomy picture.

However the most likely driver of further market deterioration is not a further decline in oil prices, but the negative sentiment itself. This is due to a flaw in the way analysts ascribe value in markets that behavioural economists call "anchoring bias".

This is the idea that people tend to start from what they know and then attempt to make appropriate adjustments based on this. Over 40 years of research has found that these adjustments tend to be insufficient.

Everyone can be prone to this bias, there are a few studies that demonstrate this. For example, when people were asked which year George Washington became the first US President, most would start from the year the US became a country (in 1776). They would reason that it might have taken a few years after that to elect the first president so they add a few years to 1776 to work it out, coming to an answer of 1778 or 1779. George Washington actually became president in 1789.

Similarly, most people would know the freezing point of water (0 degrees celcius) as compared to vodka. So if they were asked what the freezing temperature of vodka is, they would tend to start from 0 and adjust downwards. The freezing temperature of vodka is around -24 degrees celcius, much lower than what people usually answer.

Both these examples demonstrate how the reasoning associated with anchoring bias leads to people falling significantly short of the right answer.

In the case of the stock market, analysts look to the performance of blue-chip stocks linked to commodities like oil because they are associated with large, well established companies with time-tested business models. There are large data sets available with which to analyse these stocks.

However less than 4% of companies are classified as blue-chips globally. What about the remaining 96%? To value them, analysts may start from the payoffs of blue-chips and then attempt to make appropriate adjustments for size and other differences.

The overreaction of the market in relation to oil prices is further exposed by the fact that lower oil prices aren't all bad news. Low oil prices can be good for countries that import oil as well as their consumers, retailers and industry. Higher production of goods drives cheaper prices leaving more money in the pockets of consumers to spend.

Other economic indicators also tell a very different story to the oil price. Job numbers are good both in the European region and US, and growth seems to be picking up.

In fact, based on encouraging data, Fed has recently raised interest rates for the first time after nine years. The slowdown in China is not the giant collapse that some were fearing.

If analysts and investors continue to display anchoring bias and the oil price drops, it could become a self fulfilling prophecy where a prolonged market slump cuts off investment, reduces consumption, and pushes the global economy into a recession. Central banks will do what they can to prevent this from happening by talking of quantitative easing. However, the interest rates are already near zero so they do not have much room to move.

Hammad Siddiqi does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.
 Behavioural economics can explain why stock markets have been so closely following the price of oil. Hammad Siddiqi, Research Fellow in Financial Economics, The University of Queensland Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/52029 2015-12-16T19:16:19Z 2015-12-16T19:16:19Z Crowded out: how crowdsourcing for startups turned into business as usual

Crowded market. mic wernej, CC BY-NC-ND

Crowdfunding has been hailed by some as the "democratisation of finance". To many, it is viewed as a key alternative source of finance where we can all get involved in backing new companies through either donations or the purchase of equity. Unfortunately, it hasn't quite worked out like that.

There are several new financing models that use the umbrella term of crowdfunding, but they can be fundamentally different. In theory, "equity" crowdfunding lets large numbers of small investors invest in firms via online platforms – or "mini stock markets" for start-ups – regardless of their location. From a business perspective, firms should be able to draw upon a wide range of funders in the crowd, who they might never have known existed, to fund, develop and grow their businesses.

What we've found is that equity crowdfunding isn't as "new" or "inclusive" as people first envisaged.

Crowdfunding laboratory

The UK was one of the first countries to grant regulatory approval to equity crowdfunding and, through various tax incentives, has become something of a unique "laboratory" for this form of entrepreneurial finance. We have witnessed a massive growth in equity crowdfunding. It appears to be doubling in size every year, spawning well known platforms like Crowdcube, Seedrs and The Syndicate Room. In the space of three years Crowdcube alone has raised over £100m in capital for over 300 start-ups.

During 2015, we undertook the largest in-depth study to date, examining equity crowdfunding in the UK, interviewing over 60 British start-ups to get their views of why firms use equity crowdfunding, how the process works and the benefits it brings to firms.

 <img alt="" src="https://images.theconversation.com/files/106075/original/image-20151215-23186-1x3gpe0.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/106075/original/image-20151215-23186-1x3gpe0.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=383&fit=crop&dpr=1 600w, https://images.theconversation.com/files/106075/original/image-20151215-23186-1x3gpe0.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=383&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/106075/original/image-20151215-23186-1x3gpe0.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=383&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/106075/original/image-20151215-23186-1x3gpe0.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=482&fit=crop&dpr=1 754w, https://images.theconversation.com/files/106075/original/image-20151215-23186-1x3gpe0.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=482&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/106075/original/image-20151215-23186-1x3gpe0.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=482&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
 Cash hunters. Images Money, CC BY

Some of our findings confirmed what is already known – that it is filling the funding gap for young start-ups who no longer consider banks as a source of early-stage growth capital. Indeed, many start-ups are attracted to the speed with which they can raise funding and like the lack of strings attached. There are also important intangible benefits to firms from the process, such as firm valuation, product validation and media exposure.

Professional game

However, some other findings were unexpected. Contrary to the idea that crowdfunding is a transaction between firms and the "crowd", seamlessly brought together through the internet, we found that deals were often driven by pre-existing networks of investors. Roughly around two-thirds of the crowdfunding campaigns in our study were "pre-seeded" and backed by business angels (professional investors), with the crowd playing a "supporting role" where small investors are issued B-class shares that have no voting rights attached.

These professional investors are investing heavily in businesses that they know of and which are often located nearby to them; the crowd then "herd" towards firms who obtain pre-seed funding. So in many cases, equity crowdfunding isn't really a new or "alternative" source of funding, but rather a repackaging of more traditional start-up funding.

As an internet-mediated form of funding, in theory, firms should be able to access equity crowdfunding irrespective of their geographical location. In reality, however, there seems to be a large "north-south" divide in terms of successful deals, with around half of all the deal flow emanating from London and the south-east.

 <img alt="" src="https://images.theconversation.com/files/106076/original/image-20151215-23205-m8j52j.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/106076/original/image-20151215-23205-m8j52j.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=333&fit=crop&dpr=1 600w, https://images.theconversation.com/files/106076/original/image-20151215-23205-m8j52j.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=333&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/106076/original/image-20151215-23205-m8j52j.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=333&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/106076/original/image-20151215-23205-m8j52j.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=419&fit=crop&dpr=1 754w, https://images.theconversation.com/files/106076/original/image-20151215-23205-m8j52j.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=419&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/106076/original/image-20151215-23205-m8j52j.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=419&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
 London. Taking the lion's share. Steve Evans, CC BY-NC

There are a number of potential reasons for this. For example, the majority of platforms are located in London and we have found that word-of-mouth referrals through business networks are still very important in both identifying and accessing crowdfunding platforms. Many businesses also want to speak to platforms "in person" before committing to a campaign (rather than engaging virtually), and so being within visiting distance of a platform is important. So despite the internet-mediated nature of crowdfunding, where distance should be irrelevant, it is strongly concentrated in the London and the south-east ecosystem. We are currently exploring this trend further.

Tip of the Iceberg

Few non-professional investors have the knowledge to undertake their own due diligence on firms before they invest nor do they offer firms any additional value (for example through advice or support) on top of their financial contribution. Indeed, some start-ups have referred to the crowd as "dumb money". Observers have also questioned the highly inflated valuations of some of the firms funded through equity crowdfunding, many of which are internet-based firms linked to the so-called "sharing economy", and operating in consumer-oriented markets with no intellectual property or recoverable assets.

Given the high failure rate of new start-ups generally, and the nature of most crowdfunded businesses, few non-professional investors are likely to see a return on their investment any time soon.

Despite these reservations, given the current growth trajectory of equity crowdfunding, what we've seen so far may just the tip of the iceberg. However, icebergs can sink ships. While providing an important source of start-up funding, equity crowdfunding raises a number of thorny issues in terms of investor returns, investor protection, sustainability and the need for proper regulatory safeguards.

Crowdfunding has been heavily promoted by organisations such as NESTA, but the way it actually works is strangely familiar. We thus advocate a more critically informed discussion about equity crowdfunding, especially given the UK's heavily deregulated and proactive fiscal policy environment for this emerging source of entrepreneurial finance.

The authors do not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.
 The democratisation of finance isn't going quite to plan. Ross Brown, Lecturer in Entrepreneurship and Small Business, University of St Andrews Suzanne Mawson, Lecturer in Entrepreneurship, University of Stirling Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/49181 2015-10-15T16:00:46Z 2015-10-15T16:00:46Z Disneyland Paris: too big to fail?

The haunted house at Disneyland Paris. Adrien Sifre/Flickr, CC BY-SA

In a 2015 article titled "The Social Cost of Dishonesty", we showed how imperfect markets – for example, where some parties have more information than others – require the intervention of impartial authorities to adjust the balance of power and maximise the public good. The social cost of dishonesty is even higher when such authorities are absent or when they're captured by economic, corporate or electoral forces. We concluded with a number of questions that these issues raise in the worlds of journalism and finance.

In this article, the matter at hand is the ability of independent authorities to discipline a publicly traded company, Disneyland Paris, that is possibly being managed solely in the interests of its majority shareholder, The Walt Disney Company.

The agency theory, developed in the pioneering work of Michael Jensen and William Meckling, asserts that honest and efficient corporate governance, through properly designed incentives, can reduce the risk of one party's making decisions that are contrary to the collective good in order to maximise its own interests.

Good for me, not so good for you

In financial economics, such "harvest strategies" often crystallise around obvious conflicts of interest, which can increase the risk of moral hazard or adverse selection. When corporate management fails to correct such problems, it is the responsibility of outside authorities to restore a level playing field or, if necessary, sanction any misconduct or market abuse.

 <img alt="" src="https://images.theconversation.com/files/98421/original/image-20151014-15159-25ksrm.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/98421/original/image-20151014-15159-25ksrm.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=574&fit=crop&dpr=1 600w, https://images.theconversation.com/files/98421/original/image-20151014-15159-25ksrm.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=574&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/98421/original/image-20151014-15159-25ksrm.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=574&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/98421/original/image-20151014-15159-25ksrm.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=721&fit=crop&dpr=1 754w, https://images.theconversation.com/files/98421/original/image-20151014-15159-25ksrm.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=721&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/98421/original/image-20151014-15159-25ksrm.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=721&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
 Hot air: Minnie balloons at Disneyland Paris. Farrukh/Flickr, CC BY-NC

In the case of Disneyland Paris, the risk of conflict of interest is obvious given that The Walt Disney Company (TWDC) is simultaneously its largest shareholder (39.8%); the holder of the park's license, for which it collects generous royalties (€61.9 million for 2014 alone); its sole supplier, with no possible competition for new rides, decorative elements, etc; and, since the company was restructured in 2012, its sole creditor. Note that TWDC also controls 51% of the consolidated variable interest entities.

Suffice to say that from the beginning, TWDC has been in full control of the choices made by its French subsidiary, allowing it to set the broad strategic objectives, make crucial decisions, determine the level of royalties and even appoint members of the executive board (which are often employed by TWDC itself). At the same time, the company is unlikely to be exonerated of structural losses of the consolidated group or avoid its legal or moral obligations.

This being the case, it's illuminating to look at Disneyland Paris's corporate governance. The manager (in this case, TWDC) is remunerated on the basis of a fee set at 1% of annual turnover (€12.9 million in 2014), to which are added royalties for the use of intellectual property that vary between 5% and 10% of turnover depending on the products and services in question (this constitutes nearly 57% of the park's net losses over ten years). To this one we can add the considerable advantages that the European amusement park gives TWDC for its service activities (merchandising, video-on-demand subscriptions, film receipts, etc) as well as the boost that the park's colossal advertising and PR expenses (nearly 10% its annual revenue) provide to its galaxy of affiliates (Disney Hachette Presse, The Disney Store, as well as TWDC France via the Disney Channel and DVD publishing).

 <img alt="" src="https://images.theconversation.com/files/98418/original/image-20151014-15131-adejdu.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/98418/original/image-20151014-15131-adejdu.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=400&fit=crop&dpr=1 600w, https://images.theconversation.com/files/98418/original/image-20151014-15131-adejdu.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=400&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/98418/original/image-20151014-15131-adejdu.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=400&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/98418/original/image-20151014-15131-adejdu.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=503&fit=crop&dpr=1 754w, https://images.theconversation.com/files/98418/original/image-20151014-15131-adejdu.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=503&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/98418/original/image-20151014-15131-adejdu.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=503&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
 Merchandising Disney. Joan Jordi Fabrega/Flickr, CC BY-NC-SA

It should be noted that the CEOs appointed by TWDC in recent years have succeeded in boosting both Disneyland Paris's attendance (up 18.3% since 2000) and its sales (up 33.4%). But at the same time, the park has shown an annual profit just once, in 2008, and then only because of the sale of assets.

Royalties or profits?

From the economist's point of view, this intriguing situation – in which growing receipts are accompanied by rising deficits – has only one possible explanation: rising marginal costs bear witness to diminishing returns from the goods and services sold. In other words, under Disneyland Paris's business model, each new customer costs more than he or she brings in.

Moving from this realization to suspecting that Disneyland Paris is subsidizing its customers for the sole purpose of increasing the company's turnover, paying hefty royalties to its parent company (suspected to pass through Luxembourg in complex tax-avoidance scheme) and devaluing its stock price (down 95% since 1989) so that it can cheaply buy back shares is not a great leap. It is one that Charity & Investment Asset Management (CIAM) did not hesitate to make. This month it filed a complaint with France's Autorité des Marchés Financiers (the equivalent of the SEC in the US) and others demanding €930 million for damages suffered by minority shareholders because of biased actions taken by the park's management.

While it is not for us to play the judge in this case, there does seem to be a preponderance of evidence from an economist's point of view. Who benefits from the crime, after all? The intentional increase in Disneyland Paris's turnover has allowed TWDC to reap substantial returns. The park's repeated financial losses and the endless fall of its share price have, in turn, paved the way for the buyout of third parties: the park's creditors in 2012, and a substantial portion of minority stockholders in 2015 after yet another recapitalization. This now gives TWDC ownership of nearly 82% of the company's shares. At the same time, remaining minority stockholders – for whom the payment of hypothetical dividends now seems like a fever dream – received a proposition from Disney for a mandatory buy-back at €1.25 per share. CIMA has challenged this calculation, which it said intentionally undervalued the company.

 <img alt="" src="https://images.theconversation.com/files/98419/original/image-20151014-15165-gxbzpc.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/98419/original/image-20151014-15165-gxbzpc.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=401&fit=crop&dpr=1 600w, https://images.theconversation.com/files/98419/original/image-20151014-15165-gxbzpc.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=401&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/98419/original/image-20151014-15165-gxbzpc.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=401&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/98419/original/image-20151014-15165-gxbzpc.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=504&fit=crop&dpr=1 754w, https://images.theconversation.com/files/98419/original/image-20151014-15165-gxbzpc.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=504&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/98419/original/image-20151014-15165-gxbzpc.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=504&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
 The Walt Disney Company: The real Scrooge? T. Lilly/Flickr, CC BY-NC-ND

A good source of taxes

During this time, the French government examined its own situation with Disneyland Paris. It has no hope of tax receipts on nonexistent corporate profits and had already provided an endless series of gifts to the US company, including subsidized infrastructure, 4,800 acres of land sold at cost and loans at sub-market rates. In this situation, does it still have the ability to discipline – should such a thing happen – a company that pays millions of euros annually in local taxes and VAT, provides thousands of direct and indirect jobs, and which constitutes one of the top tourist destinations in France?

And even as this question reminds us of the debates around corporations that are so large or important that they can't be subject to any decisions or actions that might weaken them – the famous "too big to fail" – the words of French playwright Jules Renard resonate: "It would be beautiful indeed to see an honest lawyer request the conviction of his own client."

Translated from the French by Leighton Walter Kille.

Julien Pillot neither works nor recommend or receive funding an organization that could benefit from this article. However, he has held shares in the Euro Disney company and in his capacity as shareholder has met the leaders of the company.
 Disneyland Paris has lost money every year but one since it opened. So why doesn't Disney shut it down? Julien Pillot, Professeur associé (Université Paris Saclay) / Directeur Scientifique (Xerfi) / Chercheur associé (CNRS), Centre national de la recherche scientifique (CNRS) Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/47457 2015-09-15T04:12:00Z 2015-09-15T04:12:00Z Explainer: why stocks fall when the Fed considers raising interest rates
A top-level committee of the Federal Reserve, the US' central bank, is meeting this week to discuss when it should begin raising interest rates.

Often when a central bank lifts rates, the country's stock market falls. When the central bank cuts them, share prices go up. Typically this occurs well in advance of the actual change because investors are making bets on what they think will happen. And sometimes this seems counterintuitive, because a central bank usually raises rates when an economy is strengthening and lowers them when it's weaker.

For example, at the end of July, the Standard & Poor's 500 plunged 2% after a report signaling an improving US economy convinced traders the Fed was more likely to raise its target interest rate sooner rather than later. The same thing has played out repeatedly this year – stocks rising on signs the Fed will keep rates at about zero; shares sliding when it appears the central bank will raise them.

Why does the stock market react like this? The answer is because of an idea called "present value."

What's in a share

The value of a company's shares is based on its profits, which are the difference between a company's earnings or revenue and its costs. For example, if the Professor JayZ Company is able to sell US$10 million of products and it costs the company $7 million to make and distribute them, then the profits are $3 million.

Let's start off simply and assume that after earning $3 million, the company distributes all profits to shareholders and then closes down. Let's also make another simple assumption that there is just one share of stock available. This means whoever owns the single share gets the entire $3 million profit.

If the price for the single share was $1,000, everyone would definitely want to buy the stock because anyone getting the share would earn almost $3 million from the trade. Even at $1 million, we'd all still want to buy the stock because the trade still results in a tidy gain of $2 million.

If there was an efficient stock market with good information available to all traders, the share price would eventually rise toward $3 million. No trader would pay more than $3 million, because above that level, he or she would lose money. In this very simple world, the price of the share of stock is simply the company's profits.

Now, in real life, few companies exist just for a single year and then close. Instead, the vast majority exist for many years. What happens if the Professor JayZ Company exists for two years and each year earns $3 million in profits?

Clearly people are willing to bid more for the stock now since they will be getting a larger amount of money. However, they will have to wait some time before getting all their money, so they wouldn't want to pay $6 million. Forcing people to wait has a cost, since traders pay for the stock today and then get the profits or dividends later.

Waiting is a problem because money received in the future is not worth as much as today. The simplest way to see this is to imagine winning a million dollars today. How would your excitement change if you still won that million dollars, but the prize money wouldn't arrive for 25 years? Most people are much less interested, because a lot can happen in 25 years. Having to wait makes the prize less valuable.

How present value works

A math formula called "present value" (a good calculator is here, web page here, video here, book here) shows exactly how much less valuable money received in the future is compared with money received today.

The idea behind the formula is simple: present value is the amount of money someone would accept today instead of getting some larger amount in the future.

For example, if the interest rate is 5% and a person is expecting a $3 million profit from the JayZ Company in one year, then the present value is close to $2.86 million. Why $2.86 million? This is the amount of money that, when put in a bank with 5% interest, grows to $3 million one year from now.

However, if interest rates rise to 10%, the present value is only $2.73 million. A smaller amount needs to be put in a bank because the higher rate produces more interest.

When interest rates rise from 5% to 10%, investors value the profits earned one year from now by the JayZ company much less and are not willing to pay as much for the outstanding share of stock. When interest rates go up, share prices fall because the present value of profits earned in future years is lower. Future profits are lower because investors can put smaller amounts in the bank to earn a targeted amount.

The present value formula provides very precise estimates of what stocks are worth when interest rates are known. However, no one is able to accurately predict future interest rates. This means some traders are using high interest rates to calculate the present value of profits, while others are using low rates. As people change their expectations of future rates, stocks often move wildly.

Interest rates and profits

Beyond their importance in calculating present value, interest rates have another important impact on stock prices. Many companies borrow heavily to finance their activities.

Much corporate borrowing is not at fixed interest rates but instead at rates that change based on market conditions (floating rates). If the market interest rate goes up, then these borrowers pay more interest. Increases in interest rates mean costs rise, profits fall and share prices are reduced. Conversely, when interest rates fall, many companies report higher profits without changing any other aspect of their business, boosting their share price.

In general, stock prices are inversely related to interest rates. If everything else stays constant and you believe interest rates will rise, sell stocks now. If you believe interest rates will fall, buy stocks now.

Unfortunately, since it is difficult to accurately forecast future interest rates and all the other factors that are changing simultaneously in financial markets, this algorithm by itself will not make you instantly rich. And this week's decision by the Fed could go either way because there is broad disagreement about whether the economy is strong enough to handle a rate hike – among many other factors influencing its decision.

Nevertheless, understanding how interest rates or expectations about future interest rates affect the value of stocks is useful because it explains why the stock market changes dramatically when central banks adjust their interest rate policies.
 Whenever speculation grew louder that the Federal Reserve would lift its target interest rate this year, stocks took a dive. Here's why. Jay L. Zagorsky, Economist and Research Scientist, The Ohio State University Licensed as Creative Commons – attribution, no derivatives. tag:theconversation.com,2011:article/37144 2015-02-23T10:56:58Z 2015-02-23T10:56:58Z How retail investors can beat the pros trading on breaking news
A recent incident involving McDonald's shows how negative news on one company can cause other businesses to suffer as well, but with a delay – an insight that could help small investors reap significant trading profits.

Claiming health and safety violations, the Russian government late last year shut down a string of McDonald's restaurants and put several hundred more under heavy scrutiny. For the average Russian, McDonald's Golden Arches symbolize American capitalism.

The Russian government's move was viewed as a tactic to "exact revenge on America" for the Western sanctions following Russia's invasion of Crimea and backing of rebels in Ukraine. McDonald's earns a substantial chunk of its profit from Russian consumers, so the regulatory harassment hit the fast-food giant's bottom line hard.

McDonald's shares have flatlined since Russia first announced the investigation in August, while the Standard & Poor's 500 and the Dow Jones Industrial Averaged have jumped about 6% over the same period. Although other factors have certainly affected the company's share price – including competitive challenges in its domestic market – the sanctions likely weighed on McDonald's stock price.

Other companies feel the pain

But the pain apparently wasn't felt exclusively by the burger chain. Other companies that earn sizable revenues in the Russian market have also suffered. Shares of Ford, which sells a large number of vehicles to Russians, has lost 5.9% in the period. ExxonMobil, which is deeply invested in several Russian oil fields, has dropped 10%. Shares of US banks Citigroup and JP Morgan Chase, both with significant exposure to Russian assets, have barely budged.

Similar to the McDonald's shares, other factors have undoubtedly contributed to the poor performance of these companies' stocks. But even though the authorities haven't gone after these corporations explicitly, investors know their Russian operations are vulnerable. McDonald's setbacks signal the increased risks for all Western firms operating in Russia, and the uncertainty has only grown worse since then.

 <img alt="" src="https://images.theconversation.com/files/72544/original/image-20150219-28187-fiq981.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/72544/original/image-20150219-28187-fiq981.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=814&fit=crop&dpr=1 600w, https://images.theconversation.com/files/72544/original/image-20150219-28187-fiq981.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=814&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/72544/original/image-20150219-28187-fiq981.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=814&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/72544/original/image-20150219-28187-fiq981.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=1023&fit=crop&dpr=1 754w, https://images.theconversation.com/files/72544/original/image-20150219-28187-fiq981.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=1023&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/72544/original/image-20150219-28187-fiq981.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=1023&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
 Did somebody say capitalism? Shutterstock

The McDonald's example illustrates how news about a particular company may affect market values of other companies. Likewise, an accounting scandal may spill over to other firms that use the same auditors, a labor scandal may taint firms that use similar labor practices, a successful litigation may set the precedent for other firms to be sued, and so on.

Information may flow in unexpected directions: the company at the center of an important news development may be smaller, operate in a different industry and within a different supply chain than others also affected by the news. If investors do not know which news to follow, they may completely miss the relevant news affecting the stocks they hold.

Keeping tabs on the news is tough

Because of the sheer volume of financial news and information in the market, it is nearly impossible to keep track of all potentially relevant corporate announcements.

In research with co-authors Andreas Neuhierl and Bernd Schlusche, I estimated that about 218 corporate press releases reporting on companies' valuation-relevant news are issued by publicly traded US firms on a typical day.

Of these, only 20% involve routine announcements about earnings, sales, dividends, plans to raise or return capital, etc. The remaining 80% are about new products, partnerships, strategic plans, corporate lawsuits, expansions to new markets, changes in management and other information that is much more difficult to quantify.

Leaders and followers

Bernd Schlusche, an economist with the Federal Reserve Board, and I found that stocks at the center of an important unfolding news development lead the returns of other affected stocks by reacting first to new information. We refer to the fast-reacting stocks as "return leaders" and to stocks whose returns lag behind as "return followers."

How do we identify leaders and followers? We search for stocks that have been able to predict returns of other stocks over a trailing period of time, such as the previous one to three years.

In the McDonald's incident, for example, its stock was the first to react to the news of Russia's "retaliation," because it was at the center of it, marking it as a leader. Other stocks that subsequently fell in value, apparently as a result of the McDonald's news, would be the followers.

Our study shows that leader stocks' predictive ability continues for some time in the future.

However, the leadership can be short-lived and disappear once the issue is resolved. Since a return leader is likely to be at the center of an important news development, we find that the stocks of companies with more news stories written about them tend to have more followers – that is, the stocks whose returns lag behind the leader's returns.

How investors can profit

A company's stock price reacts quickly to news about it, but our research shows that stock prices react to the relevant news of other firms with a delay.

The best way to earn a profit from trading on news is to trade the stocks of the firm's followers. Sophisticated investors are using these trading strategies. But since the delay in the price reaction is rather short, portfolio turnover of this trading strategy is high. High portfolio turnover results in high trading costs, and trading costs are increasing in the size of trade.

Big institutional traders frequently leave money on the table because they have to trade large portfolios. Retail investors trade small dollar amounts and will incur lower trading costs. This would allow them to earn an after-trading-cost profit.

An old Wall Street adage goes: "buy on the rumor and sell on the news." Unfortunately, retail investors do not hear nearly as many rumors as big Wall Street players. For retail investors, our advice would be: "buy or sell followers on the leaders' news."

Anna Scherbina is affiliated with the AEI.
 The trick is to trade on companies linked to the news, not those in the news. Anna Scherbina, Associate Professor of Finance, University of California, Davis Licensed as Creative Commons – attribution, no derivatives.