Researchers derived a complex mathematical formula for predicting the frequency of large daily stock market movements. Though they believe that their formula rests on a solid theoretical foundation, the proof of the pudding is in the eating.
So they tested the formula not just in the U.S. stock market, but also in foreign stock markets as well as in the foreign-exchange arena. Their formula worked in those other markets too. The periods of testing were 80 years.
The researchers believe that their formula captures a universal trait of the investment world: Every market, to a more or less similar degree, is dominated by its largest investors. In this country, for example, the trades made by the large institutional investors are many orders of magnitude greater than any of ours.
And when those large investors together want to get out of stocks, the market will plunge. Yes, those institutional investors might have gotten spooked last Thursday by an erroneous trade. But we're fooling ourselves if we think it's possible to legislate away the herd instinct among the largest investors, or to prevent them from ever being spooked again in the future.
The corollary? To the extent that the regulators' trading curbs and circuit breakers and the like have any effect, it will be merely to postpone the selling for a day or two.
If the researchers are right, regulators are tilting at windmills in trying to find ways of preventing the market from rapid dives. Investors would be far better served by recognizing the big price drops, though infrequent, are an unavoidable price to pay for being invested in the stock market -- and to design their financial plans accordingly. --from marketwatch
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