“…Do not attack an enemy whose ranks are in perfect order and not to advance uphill”…sage advice from Sun Tzu’s The Art of War. Savvy investors might translate this to read, “The trend is your friend.”

Those who study stock markets and what makes a market move, have a variety of theories attempting to explain the volatility that surrounds market movements. Robert Shiller’s book, Market Volatility, advances the popular theory that uses a qualitative explanation of price fluctuations.

Shiller believes that investor reactions, due to psychological or sociological beliefs, exert a greater influence on the market than good economic sense arguments.

The popular model theory proposes that people act inappropriately to information that they receive. Shiller believes that investors factor in the uncertain future when making decisions. Since the future is unknown, it becomes an ex-post value, or dependent upon psychology.

Opposite Shiller are the Efficient Market Hypothesis (EMH) believers. These theorists believe that all investors are equally well informed and that all information, both public and private is known and represented in the stock price. The EMH group acknowledges that investors may react differently to known information, i.e. a risk adverse investor might sell as markets become bearish, more aggressive may sell short or begin buying as prices fall, making it possible for some to profit from these market inefficiencies.

Shiller accepted the fact that some price movements can be attributed to EMH, but that a greater amount of price movement, or excess volatility, can be explained by the psychological behavior of investors. If Shiller were correct, then his assertions would cast doubt on the validity of fundamental and technical analysis. Both forms of analysis could be rendered worthless if all investor behavior was attributable to psychological factors.

Investor fears and overreaction to the disappointing news have added to the excess volatility of the market. But, remember the words of Sun Tzu, and the modern day translation:

“The trend is your friend.”