tag:theconversation.com,2011:/fr/topics/stock-investors-49865/articlesStock Investors – The Conversation2023-12-11T12:37:19Ztag:theconversation.com,2011:article/2190702023-12-11T12:37:19Z2023-12-11T12:37:19ZMost investors aren’t paying attention to climate risks – the financial system needs to change<figure><img src="https://images.theconversation.com/files/563999/original/file-20231206-29-q2o1yi.jpg?ixlib=rb-1.1.0&rect=0%2C45%2C5120%2C2828&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">
</span> <span class="attribution"><a class="source" href="https://www.shutterstock.com/image-photo/financial-analysts-day-traders-working-on-2088641623">Gorodenkoff/Shutterstock</a></span></figcaption></figure><p>Climate change is increasing the frequency of extreme weather events. For example, extreme sea-level events, where large storm surges and high tides temporarily push the sea much higher than normal, currently occur once a century. However, they are <a href="https://www.ipcc.ch/report/ar6/syr/figures/figure-4-3">projected</a> to strike coastal areas every decade, if not yearly, by 2040.</p>
<p>Events like these have significant consequences for the global financial system, such as depressing economic growth. According to <a href="https://www.nber.org/system/files/working_papers/w20352/w20352.pdf">research</a>, a once-in-a-hundred year cyclone is linked to an average income loss across all countries of nearly 15% per person, surpassing the 9% average income reduction typically observed in the aftermath of a financial crisis.</p>
<p>The extensive damage that extreme weather inflicts on infrastructure, homes and the economy could also lead to debt that a country may struggle to repay, potentially making it harder for it to borrow money in the future. <a href="https://pubsonline.informs.org/doi/abs/10.1287/mnsc.2023.4869">Research</a> I carried out with colleagues found that, by 2030, climate change should result in 59 countries seeing a deterioration in their ability to repay their debts, and a subsequent increase in their cost of borrowing.</p>
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Read more:
<a href="https://theconversation.com/climate-change-is-making-debt-more-expensive-new-study-211009">Climate change is making debt more expensive – new study</a>
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<p>However, it appears that investors (fund managers in charge of large amounts of investments) are not paying attention to these risks. A recent article in the <a href="https://www.ft.com/content/830e3ae6-0c3c-4da9-87e7-4ff72aa3e249">Financial Times</a> revealed that oil and gas firms are facing virtually no additional borrowing costs, despite the fact that the future of the entire industry is at risk from the shift towards clean energy and global efforts to reduce carbon emissions.</p>
<p><a href="https://www.sciencedirect.com/science/article/abs/pii/S037842662300153X?dgcid=author">Research</a> has also found that, while investors expressed some concern about the risks associated with climate policy, the direct risks from extreme weather itself had no impact on the price of US stocks between 2000 and 2018.</p>
<p>Why are investors responding in this way? Not having access to the right information is only part of the equation. Investors also need to believe that climate change will actually have material consequences for financial markets.</p>
<figure class="align-center ">
<img alt="A bridge that has been destroyed by a hurricane." src="https://images.theconversation.com/files/563992/original/file-20231206-21-yeures.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/563992/original/file-20231206-21-yeures.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=400&fit=crop&dpr=1 600w, https://images.theconversation.com/files/563992/original/file-20231206-21-yeures.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=400&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/563992/original/file-20231206-21-yeures.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=400&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/563992/original/file-20231206-21-yeures.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=503&fit=crop&dpr=1 754w, https://images.theconversation.com/files/563992/original/file-20231206-21-yeures.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=503&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/563992/original/file-20231206-21-yeures.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">
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<span class="caption">Hurricane Katrina destroyed the Biloxi bridge in Mississippi.</span>
<span class="attribution"><a class="source" href="https://www.shutterstock.com/image-photo/hurricane-katrina-destroyed-biloxi-bridge-990842">Robert A. Mansker/Shutterstock</a></span>
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<h2>Access to information</h2>
<p>If a country seeks to borrow from financial markets for investments in public infrastructure, its credit rating will determine the cost of borrowing. The credit rating influences the interest the government will pay, akin to how an individual’s credit rating affects their mortgage repayments. </p>
<p>However, credit rating agencies <a href="https://www.ecb.europa.eu/pub/pdf/scpops/ecb.op303%7Eeaa6fe6583.en.pdf">do not</a> consistently incorporate climate risks into their assessments. Government debt simply does not have the right climate metrics for investors to make informed decisions.</p>
<p>But, when investors are given the right information, they do generally make appropriate decisions. For example, <a href="https://academic.oup.com/rfs/article-abstract/36/11/4588/7156853?redirectedFrom=fulltext">research</a> published in May 2023 explored the impact of exposure to sea-level rise on municipal bond yields in the US. (When an investor buys a municipal bond, they loan money to the local government in exchange for a number of interest payments over a defined period.)</p>
<p>Once presented with worst-case sea-level rise projections, investors adjusted their required rate of return on municipal bonds in coastal communities. In fact, a one-standard-deviation increase in exposure to rising sea levels resulted in a 7% to 10% increase in the cost of borrowing. </p>
<p>The availability of information on the financial risks associated with climate change is improving. However, much of this information is not brought together into a single place that helps financial markets analyse it.</p>
<p>Financial markets also require new tools to help them understand this new information. Part of the problem is that finance simply lacks the skills to understand environmental data.</p>
<h2>Processing it differently</h2>
<p>Access to the right information is, however, only one part of the problem. Even when investors do have access to this information, they process it differently to one another. </p>
<p>The same study suggests that investors in “less worried” (according to a survey of climate opinions) locations ignore sea-level projections completely. In the US state of North Carolina, for example, lawmakers have <a href="https://www.reuters.com/article/us-usa-northcarolina-idUSBRE86217I20120703">removed the requirement</a> for long-term sea level rise projections to be included in planning applications.</p>
<p>The effect of sea level projections (information) on municipal bonds thus appears to be conditional on investors’ prior beliefs about climate change. The findings revealed that the projected increase in the interest rate associated with rising sea levels was only present in “more worried” locations. </p>
<p>Of course, investors in these locations not only needed to be worried about climate change, they also needed the right information for it to make a difference to the markets.</p>
<figure class="align-center ">
<img alt="An aerial shot of Wrightsville beach in North Carolina." src="https://images.theconversation.com/files/563994/original/file-20231206-25-2ut3cq.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/563994/original/file-20231206-25-2ut3cq.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=450&fit=crop&dpr=1 600w, https://images.theconversation.com/files/563994/original/file-20231206-25-2ut3cq.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=450&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/563994/original/file-20231206-25-2ut3cq.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=450&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/563994/original/file-20231206-25-2ut3cq.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=566&fit=crop&dpr=1 754w, https://images.theconversation.com/files/563994/original/file-20231206-25-2ut3cq.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=566&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/563994/original/file-20231206-25-2ut3cq.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=566&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
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<span class="caption">The US coastal state of North Carolina appears to be ignoring the risk posed by climate change.</span>
<span class="attribution"><a class="source" href="https://www.shutterstock.com/image-photo/wrightsville-beach-north-carolina-usa-dusk-2297688905">Sean Pavone/Shutterstock</a></span>
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<h2>What’s the solution?</h2>
<p>Having financial data that accounts for the risks posed by climate change is a necessary requirement for incorporating these risks into asset prices. It should not be surprising that oil and gas firms maintain low borrowing costs with high credit ratings when these ratings do not consider climate risks. </p>
<p>Nevertheless, access to financial indicators that are adjusted for climate risks is only one aspect of the challenge. Before this new data is integrated into the decisions that investors make, the investors must be convinced that climate change actually holds significant consequences for financial markets. </p>
<p>In this sense, encouraging investors to recognise the impact of climate change may ultimately pose more of a sociological challenge than an economic one.</p><img src="https://counter.theconversation.com/content/219070/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Matt Burke received funding from the International Network for Sustainable Financial Policy Insights, Research and Exchange (INSPIRE).</span></em></p>Investors seem not to care about climate risks, but they really should.Matt Burke, WTW Research Fellow, University of OxfordLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1700202021-11-02T12:26:20Z2021-11-02T12:26:20ZWhy are investors so cocky? They often have a biased memory – and selectively forget their money-losing stocks<figure><img src="https://images.theconversation.com/files/429623/original/file-20211101-1361-v6hqe3.jpg?ixlib=rb-1.1.0&rect=154%2C65%2C3819%2C2806&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Investors often seem to view their performance through pink-tinted glasses. </span> <span class="attribution"><a class="source" href="https://newsroom.ap.org/detail/APPoll-StockMarket/d888fb33aa3b4a4c8d01dee3a4d4e6b3/photo?Query=stock%20traders%20happy&mediaType=photo&sortBy=arrivaldatetime:desc&dateRange=Anytime&totalCount=2&currentItemNo=0">AP Photo/Seth Wenig</a></span></figcaption></figure><p><em>The <a href="https://theconversation.com/us/topics/research-brief-83231">Research Brief</a> is a short take about interesting academic work.</em></p>
<h2>The big idea</h2>
<p>Stock investors mistakenly remember their past investments as better than they actually were, which leads them to be overconfident about how they’ll perform in the future, <a href="https://doi.org/10.1073/pnas.2026680118">according to our new study</a>.</p>
<p><a href="https://doi.org/10.1162/003355301556400">Past research</a> <a href="https://www.doi.org/10.1111/0022-1082.00226">has shown</a> that investors tend to be very overconfident. But there’s been little explanation as to why. We wondered whether a biased memory might play a role. </p>
<p>So we recruited about 900 investors – mostly men, <a href="https://www.investopedia.com/articles/investing/092315/why-are-so-few-women-finance-its-complicated.asp">who dominate the finance industry</a> – through online forums and panels and conducted three studies.</p>
<p>In the first, we asked 401 investors a series of questions intended to estimate their level of overconfidence, glean their actual performance and determine how frequently they trade. To measure overconfidence, we recorded how much they expected to beat the market over the next 12 months. We then asked them to recall, from memory, the performance of the two trades that had the biggest impact on their portfolio – whether positive or negative – over the previous year. </p>
<p>Finally, we told them to look up their financial statements and tell us how their trades actually performed. </p>
<p>We compared the figures they remembered with the figures they reported. We found that on average investors overestimated their returns from their biggest trade by 4.3 percentage points and their second-biggest gain by 7.1 points. We also found that those who had the rosiest memories were the most overconfident and tended to trade the most frequently. </p>
<p>Our second study was similar to the first except we asked 151 investors to recall up to 10 trades that had the biggest impact on their portfolios in 2020 and later show us the financial statements. With a larger sample of trades, we were able to isolate and measure the effects of two different types of <a href="https://www.sciencedaily.com/terms/list_of_memory_biases.htm">memory bias</a> – “<a href="https://courses.lumenlearning.com/boundless-psychology/chapter/memory-distortions/">distortion</a>,” when someone remembers something more positively than the reality, and “<a href="http://dx.doi.org/10.1027/1618-3169/a000409">selective forgetting</a>” – to see if they could predict overconfidence. </p>
<p>Investors thought their trades had gained an average of 8 percentage points more than they actually did. Further analysis showed that distortion played a significant role in participants’ overconfidence. And we found that investors were much more likely to selectively forget their losses than their gains.</p>
<p>We also found that participants with larger memory biases – that is, bigger gaps between the numbers they initially recalled and the actual performance of their portfolios – tended to be more overconfident and traded more frequently. </p>
<p>In our third and final study, we wanted to see if an intervention could reduce overconfidence, so we recruited 366 more investors and asked half of them to review their actual returns from their financial statements before we measured overconfidence. We found that those who saw their actual returns still expected to beat the market but by much less than those who hadn’t seen their trades. </p>
<h2>Why it matters</h2>
<p>Overconfident investors can not only be a hazard to themselves but can also contribute to massive market failures. </p>
<p>Investors brimming with confidence <a href="https://doi.org/10.1111/0022-1082.00078">are more likely to take on more debt</a>, <a href="https://doi.org/10.1287/mnsc.1090.1009">overreact to market-related news</a> and signals, buy overpriced investments and make basic mistakes than peers who are less sure of themselves.</p>
<p>This overconfidence is often a contributing factor to market bubbles and crashes, like the <a href="https://www.doi.org/10.1080/15427560.2016.1203325">2008 financial crisis</a>. Besides wiping out investors, the inevitable collapse of market bubbles ripples through the economy, often causing debt defaults, business bankruptcies and massive unemployment. </p>
<p>Our results suggest that biased memory likely contributes to this overconfidence. </p>
<h2>What’s next</h2>
<p>We’d like to push this work in two directions. We’d like to run a field experiment looking at whether we can reduce overconfidence and improve returns among brokerage clients using the insights gleaned from our studies. Second, we’d like to further investigate the psychological processes underlying these effects.</p>
<p>We also want to communicate these results more broadly to the public to help investors make smarter decisions so they are better positioned to protect and grow their wealth.</p><img src="https://counter.theconversation.com/content/170020/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>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.</span></em></p>Overconfidence is often a contributing factor to market crashes, like the financial crisis of 2008.Philip Fernbach, Associate Professor of Marketing, University of Colorado BoulderDaniel Walters, Assistant Professor, INSEADLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1624912021-06-16T12:39:41Z2021-06-16T12:39:41ZA court ruling on Shell’s climate impact and votes against Exxon and Chevron add pressure, but it’s the market that will drive oil giants to change<figure><img src="https://images.theconversation.com/files/406236/original/file-20210614-73420-m5npn0.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Fossil fuel stocks haven't kept up with the market in recent years.</span> <span class="attribution"><a class="source" href="https://www.gettyimages.com/detail/photo/oil-pump-with-candle-stick-graph-chart-in-the-royalty-free-image/1213625754">Anton Petrus via Getty Images</a></span></figcaption></figure><p>From news reports, it might sound like the fossil fuel industry is on the defensive after a <a href="https://uitspraken.rechtspraak.nl/inziendocument?id=ECLI:NL:RBDHA:2021:5339">landmark court ruling</a> and two <a href="https://www.chevron.com/-/media/chevron/stories/documents/chevron-2021-shareholder-proposal-voting-results.pdf">shareholder</a> <a href="https://www.blackrock.com/corporate/literature/press-release/blk-vote-bulletin-exxon-may-2021.pdf">votes</a> challenging the industry’s resistance to curbing its greenhouse gas emissions.</p>
<p>But how much power do decisions like these really carry when it comes to pressuring the industry to change? As an academic who studies climate finance and is familiar with climate litigation, I think there’s something else at work here.</p>
<h2>Pressure from the courts</h2>
<p>This latest flurry of speculation about the future of the industry began on May 26, 2021, when a Dutch court <a href="https://uitspraken.rechtspraak.nl/inziendocument?id=ECLI:NL:RBDHA:2021:5339">ordered Royal Dutch Shell to cut its emissions</a> 45% by 2030 from 2019 levels. That includes emissions from vehicles that burn Shell’s gasoline, something for which the oil industry has never been held legally liable.</p>
<p>Digging <a href="https://uitspraken.rechtspraak.nl/inziendocument?id=ECLI:NL:RBDHA:2021:5337">deeper into the court’s decision</a>, it is clear that the judges paid attention to science. The court agreed that greenhouse gas emissions pose a significant risk to the climate and that only so much more carbon can be released globally if the world hopes to avoid warming the planet by more than 1.5 degrees Celsius over preindustrial levels – the limit agreed to globally under the <a href="https://unfccc.int/process-and-meetings/the-paris-agreement/the-paris-agreement">Paris climate accord</a>. The court held Shell partly responsible for this increase. </p>
<p>The decision appears to hinge on a violation of the Dutch Civil Code’s “unwritten standard of care,” which, according to the court, means that “acting in conflict with what is generally accepted according to unwritten law is unlawful.” Shell “must observe the due care exercised in society,” the court wrote.</p>
<figure class="align-center ">
<img alt="Shell's CEO speaking in front of a photo of fossil fuel workers" src="https://images.theconversation.com/files/406238/original/file-20210614-126997-1ihyc3m.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/406238/original/file-20210614-126997-1ihyc3m.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=400&fit=crop&dpr=1 600w, https://images.theconversation.com/files/406238/original/file-20210614-126997-1ihyc3m.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=400&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/406238/original/file-20210614-126997-1ihyc3m.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=400&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/406238/original/file-20210614-126997-1ihyc3m.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=503&fit=crop&dpr=1 754w, https://images.theconversation.com/files/406238/original/file-20210614-126997-1ihyc3m.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=503&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/406238/original/file-20210614-126997-1ihyc3m.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">
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<span class="caption">After the ruling, Shell CEO Ben van Beurden wrote on LinkedIn that his company would accelerate its emissions reduction strategy, but ‘for a long time to come we expect to continue providing energy in the form of oil and gas.’</span>
<span class="attribution"><a class="source" href="https://www.gettyimages.com/detail/news-photo/ben-van-beurden-chief-executive-officer-of-royal-dutch-news-photo/482332074?adppopup=true">Justin Tallis/AFP via Getty Images</a></span>
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<p><a href="https://www.spglobal.com/platts/en/market-insights/latest-news/electric-power/052621-dutch-court-tells-shell-to-cut-emissions-by-45-by-2030">Shell plans to appeal</a> the ruling in the Dutch court, and that doubtlessly will involve a protracted debate on what “unlawful” means in the context of the Dutch Civil Code. </p>
<p>I cannot imagine that the Dutch Civil Code will hold much sway with the U.S. federal court system. </p>
<p>Despite dozens of U.S. lawsuits by <a href="https://www.law.nyu.edu/centers/state-impact/issues/climate-action/local-suits-against-oil-companies">cities</a>, <a href="https://www.law.nyu.edu/centers/state-impact/issues/climate-action/suits-against-oil-companies">states</a> and people facing the consequences of climate change, the industry has not yet been held liable by the Supreme Court for producing and marketing fossil fuels, even though strong evidence attributes greenhouse gas emissions to oil and gas operations. In several cases, judges ruled that climate policy is the responsibility of the executive and legislative branches, <a href="http://columbiaclimatelaw.com/files/2018/06/oakland-v-bp-order-6-25-18.pdf">not the courts</a>. </p>
<p>Courts are also very slow to act. Recall that Exxon’s response to the Exxon Valdez oil tanker spill in 1989 <a href="https://www.adn.com/projects/article/exxon-valdez-case-timeline/2008/06/25/">tied up the courts for over a decade</a>. President Joe Biden’s <a href="https://storage.courtlistener.com/recap/gov.uscourts.lawd.179675/gov.uscourts.lawd.179675.140.0.pdf">ban on new oil and gas leases on federal land and water is now caught up in the courts</a> after a federal district judge issued a preliminary injunction on June 15, 2021, halting it. </p>
<p>So, while the lawsuits may add public pressure, the courts aren’t the major forces of change right now. </p>
<h2>Investors and the markets hold more power</h2>
<p>The same day the Dutch court ruled on Shell’s case, <a href="https://www.chevron.com/-/media/chevron/stories/documents/chevron-2021-shareholder-proposal-voting-results.pdf">Chevron shareholders</a> approved a resolution to require their San Francisco-based company to also curb “scope 3” emissions – the emissions created by the use of the company’s products. And Exxon shareholders, with the support of the world’s largest investment fund manager, Blackrock, voted to oust <a href="https://www.blackrock.com/corporate/literature/press-release/blk-vote-bulletin-exxon-may-2021.pdf">three board members</a> and replace them with experts in renewable energy and climate science.</p>
<p>With the Chevron and Exxon shareholder votes, it is important to recognize that the bulk of majority-vote proposals are either <a href="https://www.sciencedirect.com/science/article/pii/S0929119909000522">not implemented</a> or are watered down in multiple rounds of <a href="https://www.gibsondunn.com/wp-content/uploads/2020/08/shareholder-proposal-developments-during-the-2020-proxy-season.pdf">subsequent votes</a>. Whether they ultimately are successful depends much more on negotiations between the shareholders and the company.</p>
<p>It’s investors like Blackrock that can tip the scales. With Blackrock on the side of shareholders who are pushing for change, it is possible that the two oil majors will be forced to adopt a more climate-friendly investment strategy.</p>
<p>Blackrock, Vanguard and State Street have immense power in the boardroom. They are now the among the biggest shareholders in U.S. oil and gas companies, currently owning <a href="https://money.cnn.com/quote/shareholders/shareholders.html?symb=XOM&subView=institutional">18.5%</a> of Exxon and <a href="https://money.cnn.com/quote/shareholders/shareholders.html?symb=CVX&subView=institutional">19.4%</a> of Chevron. They also own around 20% of companies in the <a href="https://www.bloomberg.com/news/features/2020-01-09/the-hidden-dangers-of-the-great-index-fund-takeover">S&P 500</a>, including a <a href="https://www.citigroup.com/citi/investor/quarterly/2021/ar21p.pdf">large chunk</a> of shares in the big banks that finance these companies. </p>
<p>But their decisions are based on their own best interests. They are also often required to generate returns broadly equivalent to a fully diversified stock index such as the S&P 500. Blackrock said in <a href="https://www.blackrock.com/corporate/literature/press-release/blk-vote-bulletin-exxon-may-2021.pdf">explaining its vote</a>: “We believe more needs to be done in Exxon’s long-term strategy and short-term actions in relation to the energy transition in order to mitigate the impact of climate risk on long-term shareholder value.”</p>
<p>The strongest incentive for the fossil fuel industry to change may, therefore, be the discipline of large investors in the financial markets. When large investors such as Blackrock do not receive returns on their investments commensurate with the financial risk, they take action, either by cutting back their holdings or by using their voting power to effect change.</p>
<p>While I believe this is a step in the right direction, don’t count on this as an ideal solution, however, because Blackrock and the other large asset funds tend to <a href="https://static1.squarespace.com/static/59a706d4f5e2319b70240ef9/t/60a546a143620916d2b847d3/1621444259460/AsYouSow2021_ProxyVotingBiasReport_FINv9_20210518.pdf">promote corporate change</a> that benefits their investors, not necessarily the public at large.</p>
<h2>The market has started paying attention</h2>
<p>Several years ago, <a href="https://doi.org/10.1111/1911-3846.12298">I produced evidence</a> that when investors assessed firms with higher greenhouse gas emissions, they considered the potential costs of future lawsuits and regulation, both of which might affect stock prices. At the time, however, the market paid little attention to this liability, perhaps because of Exxon’s successful track record in defending against climate lawsuits.</p>
<p>In <a href="https://doi.org/10.1016/j.eneco.2015.08.028">another paper</a>, I showed that the market paid lip service to the carbon budget – the amount of carbon science shows can be emitted before the global temperature increase exceeds 1.5 degrees Celsius – and to evidence that fossil fuel assets might lose value in a warmer world.</p>
<p>That’s no longer the case. Markets are now paying close attention to both. The past decade has seen the <a href="https://www.cazenovecapital.com/uk/financial-adviser/insights/talking-points/the-longest-bull-market-in-history-in-five-charts/">strongest bull market</a> in 50 years. Yet investments in <a href="https://carbontracker.org/investors-shy-away-from-fossil-stocks-as-share-offerings-lose-billions/">fossil fuel stocks lost about 20%</a> of their value over the same decade. The price of carbon in Europe, meanwhile, <a href="https://carbonpricingdashboard.worldbank.org/map_data">has doubled</a> in the past 12 months.</p>
<p>Both trends have occurred, in my view, because of a greater realization of the high risks and consequences of climate regulation and lawsuits.</p>
<p><iframe id="eirBy" class="tc-infographic-datawrapper" src="https://datawrapper.dwcdn.net/eirBy/2/" height="400px" width="100%" style="border: none" frameborder="0"></iframe></p>
<p>Can energy firms produce higher returns by embracing the energy transition to clean energy? Given their large shareholdings, it is reasonable to conclude that Blackrock, Vanguard and State Street seem to think so.</p>
<p>So, in my estimation, it is not the courts that will force the fossil fuel industry to curb emissions. At least in the near term, it appears that what will make the difference will be a change in investors’ strategies, away from high-risk, high-carbon investments and toward cleaner products and services that can earn superior returns for shareholders.</p>
<p>Time will tell. But I would bet on Blackrock, Vanguard and State Street and the financial markets as better instruments to lower or eliminate the carbon emissions of the large oil and gas companies, not the courts.</p>
<p>[<em>Like what you’ve read? Want more?</em> <a href="https://theconversation.com/us/newsletters/the-daily-3?utm_source=TCUS&utm_medium=inline-link&utm_campaign=newsletter-text&utm_content=likethis">Sign up for The Conversation’s daily newsletter</a>.]</p><img src="https://counter.theconversation.com/content/162491/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>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.</span></em></p>When big investors like Blackrock get worried about their returns, they have the power and incentive to make fossil fuel companies take action.Paul Griffin, Distinguished Professor of Management, University of California, DavisLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1550842021-02-11T19:09:07Z2021-02-11T19:09:07ZInvestors swoon over Bumble’s IPO – but what exactly is an initial public offering?<figure><img src="https://images.theconversation.com/files/383870/original/file-20210211-23-1gdqo2i.jpg?ixlib=rb-1.1.0&rect=332%2C7%2C4826%2C3426&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Bumble's IPO raised $2.15 billion for the women-go-first dating app.</span> <span class="attribution"><a class="source" href="https://www.gettyimages.com/detail/news-photo/an-afp-journalist-holds-his-phone-showing-the-dating-news-photo/1203460431">Eric Baradat/AFP via Getty Images</a></span></figcaption></figure><p>Bumble <a href="https://www.investors.com/news/technology/bumble-ipo-initial-public-offering-trades-thursday-bmbl-mtch/">raised US$2.15 billion in an initial public offering</a>, or IPO, late on Feb. 10, just in time for Valentine’s Day. Investors swooned over the women-go-first dating app, buying more shares and at a higher price than initially expected, valuing the company at $8.3 billion. </p>
<p>But what exactly is an IPO? </p>
<p>As a <a href="https://wvu.academia.edu/JFluharty">finance professor</a>, I believe understanding IPOs are an important part of knowing how markets work. More interesting to me, however, is how a new type of IPO is growing in popularity – including among the Redditors who are upending financial markets – and allowing more investors than ever to buy into the “hype” when a company goes public.</p>
<h2>Why companies go public</h2>
<p>Companies use IPOs – known as “going public” – to access the deep pockets of the U.S. stock market. At the end of 2020, <a href="https://siblisresearch.com/data/us-stock-market-value/">the IPO market was valued at over $50 trillion</a>.</p>
<p>To <a href="https://www.investopedia.com/terms/i/ipo.asp">understand what an IPO is</a>, think about starting a private business. You might deposit $50,000 into a bank account, purchase equipment and start operations. However, eventually, you will run out of money if you need to expand – especially if you are growing quickly.</p>
<p>To make life a little easier, you may attempt to obtain money from your friends or family or secure a loan from a bank. Similarly, public companies can access the stock market to raise money from investors in exchange for the promise of future profits and returns.</p>
<p>But in order to do that, first the company must go public.</p>
<p>When a business decides to go through with an IPO, it first goes to an investment banker – the same way you might go to a real estate broker when you decide to sell your house. The banker does all the same things that a broker might do, such as appraising the business by determining its value and risk and trying to match the company that is going public with well-heeled buyers who might be interested in buying a share of it. </p>
<p>In some cases, the banker might act more like a used car dealer, in which case the investment bank buys the company’s shares for a set price and then sells them to other investors later on at – it hopes – a profit. </p>
<p>In any case, the company going public doesn’t sell its new shares to “regular investors.” Instead the banks handling the deal turn to their favored wealthy clients, who initially buy shares and then sell them on to the public when the stock begins trading – usually at much higher prices than they paid. <a href="https://www.sec.gov/rules/final/2020/33-10824.pdf">Legal restrictions</a> mean the average individual cannot buy shares directly from an investment bank. So you typically need to be an accredited investor to be qualified, and trading app Robinhood’s army of day traders likely wouldn’t be eligible. </p>
<p>Success for an IPO typically means two things: The company gets as much as or more money than it aimed for, and the price “pops” on the first day of trading. </p>
<p>In Bumble’s case, <a href="https://www.sec.gov/Archives/edgar/data/1830043/000119312521025246/d20761ds1a.htm">it initially offered 34.5 million shares</a> at a price of $28 to $30, but <a href="https://seekingalpha.com/news/3660867-bumble-sets-ipo-at-39-dollars-a-share">overwhelming demand meant</a> it was able to sell 50 million at $43. That allowed it to raise well more than double the capital it had earlier planned on. </p>
<p>As far as whether early investors will get a first-day boost, <a href="https://finance.yahoo.com/quote/BMBL/">BMBL surged to $70.31</a> on Feb. 11 in its first day of trading on the NASDAQ stock exchange, creating a hefty profit for investors who bought into the IPO and sold their shares.</p>
<h2>Rise of the SPAC</h2>
<p>However, there’s a new IPO method in town that is becoming an increasingly common way for companies to go public: the SPAC IPO. </p>
<p>SPAC stands for special purpose acquisition company, and they have suddenly become the next big thing among <a href="https://www.reddit.com/r/wallstreetbets/comments/gy62lm/basic_introduction_to_spacs/">Redditors on WallStreetBets</a> who <a href="https://www.cnn.com/2021/01/27/investing/gamestop-reddit-stock/index.html">fueled the skyrocketing prices</a> of GameStop, AMC, silver and other securities in recent weeks. The zero-comission trading app Robinhood, which had been the Redditors’ favored place to buy stocks, <a href="https://www.pymnts.com/news/ipo/2021/robinhood-marches-on-with-ipo-despite-gamestop-trading-debacle/">is even considering doing a SPAC</a> rather than a normal IPO as it seeks to go public. </p>
<p>The difference is that a SPAC is like an IPO in reverse. An investor-led fund does an actual IPO – raising money from other elite Wall Street types – but with a shell of a company that has no operations. Known as a “blank check” business, its entire purpose is to eventually purchase an unspecified private company, thus making it public as well, and <a href="https://www.sec.gov/corpfin/disclosure-special-purpose-acquisition-companies">typically has two years to do it</a>.</p>
<p>In 2020, there were about the same number of <a href="https://insight.factset.com/u.s.-ipo-market-spacs-drive-2020-ipos-to-a-new-record">traditional IPOs as SPACs</a> for the first time <a href="https://www.econstor.eu/bitstream/10419/177392/1/2017-02-12%20SPAC%20IPOs%20Chapter%20SSRN.pdf">since the first SPAC was created in 2003</a>.</p>
<p>The upshot is that essentially anyone can invest in a SPAC and acquire a piece of the once-private company. Of course, this is also a very speculative investment, and it’s easy to lose everything. But that can be true of any IPO, which <a href="https://www.barrons.com/articles/SB52133021052493823286804580163941038934092">have historically underperformed the market</a>. </p>
<p>In other words, as always, <a href="https://corpgov.law.harvard.edu/2020/11/19/a-sober-look-at-spacs/">buyer beware</a>.</p>
<p>[<em>Insight, in your inbox each day.</em> <a href="https://theconversation.com/us/newsletters/the-daily-3?utm_source=TCUS&utm_medium=inline-link&utm_campaign=newsletter-text&utm_content=insight">You can get it with The Conversation’s email newsletter</a>.]</p><img src="https://counter.theconversation.com/content/155084/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Jonathan T. Fluharty-Jaidee 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.</span></em></p>A finance scholar explains what an IPO is, how it works and a new way companies are going public that’s winning the hearts of WallStreetBets Redditors.Jonathan T. Fluharty-Jaidee, Assistant Department Chair and Professor of Finance, West Virginia UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1235602019-09-17T20:18:18Z2019-09-17T20:18:18ZWall Street is ignoring the omens of recession – here’s why<figure><img src="https://images.theconversation.com/files/292871/original/file-20190917-19083-1xltqir.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Why is this man smiling?
</span> <span class="attribution"><a class="source" href="http://www.apimages.com/metadata/Index/Financial-Markets-Wall-Street/ed7d188d87344e5caab8c8aa639a2dfb/21/0">AP Photo/Richard Drew</a></span></figcaption></figure><p>The world is on the <a href="https://www.cnn.com/business/live-news/recession-fears-august-2019/index.html">brink of a recession</a>, if all the <a href="https://www.businessinsider.com/next-recession-credit-investor-fears-at-record-high-baml-survey-2019-9">breathless</a> <a href="https://fortune.com/2019/09/11/is-recession-coming-us-manufacturing-trump-country/">headlines</a> are to be <a href="https://www.cnn.com/2019/09/06/business/recession-yield-curve-ny-fed/index.html">believed</a>. So why are U.S. stocks near all-time highs?</p>
<p>That’s a question my <a href="http://www.bu.edu/questrom/">MBA students</a> have been asking me lately. Even the Federal Reserve is concerned – at least <a href="https://www.bloomberg.com/news/articles/2019-09-18/fed-makes-second-straight-rate-cut-splits-on-further-action?srnd=premium">worried enough</a> to reduce U.S. borrowing costs for the second time this year. </p>
<p>Stocks are <a href="https://www.investopedia.com/investing/why-do-companies-care-about-their-stock-prices/">usually considered a barometer</a> of a company’s future prospects, so rationally you’d think market prices would be a lot lower if a <a href="https://www.cnbc.com/2019/09/11/trump-approval-rating-on-the-economy-falls-during-recession-fears.html">recession were close at hand</a>. After all, recessions are a drop in economic activity, which means consumers and businesses are buying less stuff. </p>
<p>The answer to <a href="http://businessmacroeconomics.com/">my students’ question</a> has a lot to do with profits and interest rates, but also “animal spirits.”</p>
<h2>Moving in mysterious ways</h2>
<p>Both the <a href="https://www.bloomberg.com/quote/INDU:IND">Dow Jones Industrial Average</a> and the <a href="https://www.bloomberg.com/quote/SPX:IND">Standard & Poor’s 500</a>, Wall Street’s two main gauges for the U.S. economy, hit record highs in July and have been hovering near them ever since. </p>
<p>At the same time, <a href="https://theconversation.com/how-to-invest-if-youre-worried-a-recession-is-coming-122003">signs</a> of <a href="https://theconversation.com/how-to-invest-if-youre-worried-a-recession-is-coming-122003">trouble</a> for the global economy – and the U.S. – <a href="https://markets.businessinsider.com/news/stocks/baml-fund-manager-survey-finds-fears-of-recession-at-highest-since-2009-2019-9-1028529820">have been growing</a>. By Deutsche Bank’s reckoning, U.S. stocks <a href="https://www.marketwatch.com/story/the-sp-500-should-be-13-lower-because-a-recession-is-coming-warns-deutsche-bank-2019-09-17">should be 13% lower</a> than they are today. </p>
<p>But understanding exactly why stock markets move up or down is exceptionally difficult. </p>
<p>One of the greatest economists of all time, John Maynard Keynes, believed there were “<a href="https://www.economist.com/media/pdf/animal-spirits-akerloff-e.pdf">animal spirits</a>” – essentially, emotions, instincts and other unquantifiable human behavior – that drove people to waves of optimism or pessimism, as he explained in his 1936 book “<a href="https://www.palgrave.com/gp/book/9783319703435">The General Theory of Employment, Interest and Money</a>.”</p>
<p>Keynes believed these “spirits” had a huge influence on financial market prices and conditions. But beyond these mysterious movements there are two primary factors that push overall stock prices up and down: profits and interest rates.</p>
<h2>Profit sharing</h2>
<p>The value of a public company and its shares is based on its profits. </p>
<p>Profits are just the difference between a business’s sales and its costs. Buying shares in a company gives the buyer a claim on a portion of these profits. During an economic expansion, <a href="https://hbr.org/2019/04/companies-need-to-prepare-for-the-next-economic-downturn">profits go up</a>. During a recession, profits for most companies go down.</p>
<p>Stock prices are directly related to profits because when profits rise companies have more money to give out to shareholders in dividends. This makes stocks more valuable. </p>
<p>Rising profits also mean companies have <a href="https://www.cnn.com/2019/07/30/investing/stock-buybacks-debt-leverage/index.html">more money to buy back their own shares</a>, which leaves fewer available on the open market. This reduction pushes stock prices up because each one now gets a slightly larger share of profits. </p>
<p>The impact of a share buyback is no different from what happens when any kind of product becomes hard to find. Sellers see lots of demand while they have relatively little product to supply. To balance this excess demand, they raise prices.</p>
<p><a href="https://www.cbsnews.com/news/heres-the-most-recent-sign-the-economy-is-headed-for-recession/">During recessions, companies’ profits fall</a>. Less profit means lower dividends and less money for share buybacks. Both of these reduce share prices since there is less incentive to invest.</p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/292870/original/file-20190917-19040-366mx2.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/292870/original/file-20190917-19040-366mx2.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=400&fit=crop&dpr=1 600w, https://images.theconversation.com/files/292870/original/file-20190917-19040-366mx2.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=400&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/292870/original/file-20190917-19040-366mx2.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=400&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/292870/original/file-20190917-19040-366mx2.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=503&fit=crop&dpr=1 754w, https://images.theconversation.com/files/292870/original/file-20190917-19040-366mx2.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=503&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/292870/original/file-20190917-19040-366mx2.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">
<figcaption>
<span class="caption">Federal Reserve Chair Jerome Powell has been easing monetary policy in recent months.</span>
<span class="attribution"><a class="source" href="http://www.apimages.com/metadata/Index/Global-Economy/49214b2c4de642cbb327f48044701425/171/0">AP Photo/Kiichiro Sato</a></span>
</figcaption>
</figure>
<h2>The impact of interest rates</h2>
<p>The connection between profits and stock market prices is fairly easy to understand. Interest rates, on the other hand, are a bit less straightforward but are just as potent at driving stock prices. </p>
<p>In simple terms, stock prices are inversely related to interest rates. When interest rates fall, <a href="https://www.investopedia.com/investing/how-interest-rates-affect-stock-market/">stock prices usually go up</a>. And when rates rise, stock prices tend to fall.</p>
<p>Interest rates have this effect because <a href="https://www2.deloitte.com/us/en/insights/economy/issues-by-the-numbers/rising-corporate-debt-levels.html">many companies borrow money</a> to operate their business. When interest rates fall, it costs less to run the company since businesses pay less to service their debts, boosting profits. On the other hand, when rates rise, costs go up, squeezing corporate earnings. </p>
<p>Lower interest rates also boost the share prices of companies that don’t borrow money because they <a href="https://www.investopedia.com/calculator/pvcal.aspx">increase the present value</a> of their future profits. This is why money earned tomorrow is worth less than money earned today. </p>
<p>The simplest way to see this is to imagine <a href="https://theconversation.com/how-winning-1-54-billion-in-mega-millions-could-still-lead-to-bankruptcy-105275">winning a million dollars</a> right now. You’d be a lot less thrilled, however, if you were told you wouldn’t receive a dime for 25 years. And so lotteries typically let winners <a href="https://theconversation.com/got-the-winning-lottery-ticket-an-economist-explains-what-to-do-with-all-that-money-105700">take a greatly reduced lump sum</a> immediately or receive the total in smaller payouts over many years. </p>
<p>It’s the level of interest rates that determine just how much future income is worth today. Higher rates reduce the value of future prizes and profits; lower rates increase it. </p>
<h2>What occupies Wall Street</h2>
<p>To understand why stocks keep going up, we have to consider what profits and interest rates are doing, and what Wall Street traders are focused on. </p>
<p>Corporate profits, which have been <a href="https://www.bloomberg.com/opinion/articles/2019-09-01/corporate-profits-are-down-but-wages-are-up">hitting their own record highs</a> in recent years, <a href="https://www.cbsnews.com/news/heres-the-most-recent-sign-the-economy-is-headed-for-recession/">are currently stagnating</a> and are forecast to dip as a result of the <a href="https://www.thestreet.com/markets/rates-bonds/chart-corporate-profits-are-stagnating-15088966">trade war</a>. </p>
<p>However, central bankers around the world are also worried about a recession. They are working hard to prevent this recession by driving down interest rates now. For example, the European Central Bank on Sept. 12 <a href="https://www.nytimes.com/2019/09/12/business/ecb-europe-recession-stimulus.html">cut a key interest rate</a> and took other steps to ease borrowing costs for companies and businesses. And the <a href="https://www.wsj.com/articles/powell-set-to-address-economic-outlook-ahead-of-fed-meeting-11567762202">Fed followed suit</a> on Sept. 18 with a quarter-point reduction. </p>
<p>Lower interest rates encourage consumers, businesses and governments to borrow and spend more money – and boost the value of stocks. Although some investors are concerned about a recession, apparently most believe actions by the Fed and other central banks will be enough to keep the global economy humming – or at least enough to keep corporate profits high. </p>
<p>How long will the rising stock market continue? Who knows. But that’s what makes following financial markets so interesting for academics and so frustrating for individual investors.</p>
<p>[ <em>Deep knowledge, daily.</em> <a href="https://theconversation.com/us/newsletters?utm_source=TCUS&utm_medium=inline-link&utm_campaign=newsletter-text&utm_content=deepknowledge">Sign up for The Conversation’s newsletter</a>. ]</p><img src="https://counter.theconversation.com/content/123560/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>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.</span></em></p>An economist unravels the seeming contradiction between stocks flirting with all-time highs and growing fears of a recession.Jay L. Zagorsky, Senior Lecturer, Boston UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/1220032019-08-21T12:32:30Z2019-08-21T12:32:30ZHow to invest if you’re worried a recession is coming<figure><img src="https://images.theconversation.com/files/288605/original/file-20190819-123727-5d7g7l.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Even the pros don't know what's up. </span> <span class="attribution"><span class="source">AP Photo/Richard Drew</span></span></figcaption></figure><p>Although the U.S. economy <a href="https://www.cnbc.com/2019/07/26/us-gdp-second-quarter-2019.html">continues to grow</a> and <a href="https://finance.yahoo.com/news/july-2019-jobs-report-bls-215030223.html">add jobs</a>, <a href="https://www.cnbc.com/2019/08/15/trump-wants-fed-rate-cuts-unclear-if-they-would-help.html">talk</a> of a <a href="https://finance.yahoo.com/news/recession-will-be-a-slow-motion-accident-strategist-131602319.html">recession</a> is <a href="https://trends.google.com/trends/explore?date=all&geo=US&q=Recession">increasingly in the air</a> due to a number of worrying signs.</p>
<p><a href="https://www.bloomberg.com/opinion/articles/2019-08-14/u-s-businesses-are-stuck-in-trade-war-uncertainty">Business investment</a> and <a href="https://www.bloomberg.com/news/articles/2019-08-16/trump-economy-loses-luster-for-independents-in-2020-warning-sign?srnd=premium">consumer confidence</a> 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 <a href="https://fred.stlouisfed.org/graph/fredgraph.png?g=mtiz">inverted yield curve</a> – <a href="https://www.washingtonpost.com/business/2019/08/14/stocks-tank-another-recession-warning-surfaces">is spooking investors</a>. 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 <a href="https://www.washingtonpost.com/politics/trump-confirms-hes-considering-a-payroll-tax-cut-amid-mounting-economic-concerns/2019/08/20/2c97e500-c37a-11e9-9986-1fb3e4397be4_story.html">is even mulling a payroll tax cut</a> to avert a downturn. </p>
<p>A question I’m often asked as a <a href="https://scholar.google.com/citations?user=JfUEmSUAAAAJ&hl=en&oi=ao">finance professor</a> and a <a href="https://www.cfainstitute.org/en/programs/cfa/charter">CFA charterholder</a> 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. </p>
<p>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.</p>
<h2>Most of us have money at risk</h2>
<p>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. <a href="https://www.federalreserve.gov/publications/files/scf17.pdf">About half of American families own stocks</a> either directly or through institutional investment vehicles like mutual funds. </p>
<p>Most of the invested wealth average Americans hold is managed by professional investors who look after it for us. But the <a href="https://www.cnbc.com/2017/01/04/a-brief-history-of-the-401k-which-changed-how-americans-retire.html">continued growth</a> 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.</p>
<p>Unfortunately, most people are not good investors. Individual investors who trade stocks <a href="http://dx.doi.org/10.2139/ssrn.219228">underperform the market</a> – and passive investors – by a wide margin. The more they trade, the worse they do. </p>
<p>One reason is because the pain of losses is about <a href="https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/loss-aversion/">twice as strong</a> 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.</p>
<p>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. </p>
<h2>Investing checklist</h2>
<p>First of all, don’t make any rash moves because of the growing chatter about recession or any wild gyrations on Wall Street. </p>
<p>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.</p>
<ol>
<li><p>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 <a href="https://www.goodreads.com/quotes/499411-if-you-don-t-know-where-you-re-going-you-ll-end-up">once said</a>, “If you don’t know where you are going, you’ll end up someplace else.” </p></li>
<li><p>Assess <a href="https://www.investopedia.com/articles/pf/07/risk_tolerance.asp">how much risk</a> 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. </p></li>
<li><p><a href="https://money.usnews.com/investing/investing-101/articles/why-diversification-is-important-in-investing">Diversify your portfolio</a>. In general, riskier assets like stocks compensate for that risk by offering <a href="https://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp">higher expected returns</a>. 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. </p></li>
<li><p>Don’t try to pick individual stocks, identify the <a href="https://www.vanguard.com/pdf/icrwmf.pdf">best-performing actively managed funds</a> 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 <a href="https://www.thebalance.com/past-performance-is-no-guarantee-of-future-results-357862">may not continue to do so</a> in the future. </p></li>
<li><p>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 <a href="https://www.thebalance.com/investing-in-low-cost-index-funds-357951">have very low fees</a> yet <a href="https://www.cnbc.com/2019/03/15/active-fund-managers-trail-the-sp-500-for-the-ninth-year-in-a-row-in-triumph-for-indexing.html">produce higher returns</a> than the <a href="https://ssrn.com/abstract=1356021">majority of actively managed funds</a>. </p></li>
<li><p>Continue to make regular contributions to your investments, even during a recession. Try to set aside as much as you can afford. Many employers <a href="http://longevity.stanford.edu/sightlines-financial-security-special-report-mobile/">even match</a> all or some of your personal retirement contributions. Unfortunately, most Americans are <a href="http://longevity.stanford.edu/sightlines-financial-security-special-report-mobile/#retirement">not saving enough</a> for retirement. <a href="https://financialengines.com/docs/financial-engines-401k-match-report-050615.pdf">One in 4 Americans</a> 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. </p></li>
<li><p>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 <a href="https://www.vanguard.com/pdf/ISGPORE.pdf">about once a year</a>, rebalance your portfolio to match your long-term allocation targets. Doing so can make a <a href="https://www.forbes.com/sites/investor/2011/11/16/does-portfolio-rebalancing-work/#1fc4f9548393">big difference in performance</a>.</p></li>
</ol>
<p>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. </p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/288824/original/file-20190820-170922-1a1wkr5.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/288824/original/file-20190820-170922-1a1wkr5.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=402&fit=crop&dpr=1 600w, https://images.theconversation.com/files/288824/original/file-20190820-170922-1a1wkr5.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=402&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/288824/original/file-20190820-170922-1a1wkr5.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=402&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/288824/original/file-20190820-170922-1a1wkr5.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=505&fit=crop&dpr=1 754w, https://images.theconversation.com/files/288824/original/file-20190820-170922-1a1wkr5.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=505&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/288824/original/file-20190820-170922-1a1wkr5.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=505&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">Warren Buffett knows a thing or two about investing.</span>
<span class="attribution"><a class="source" href="http://www.apimages.com/metadata/Index/Earns-Berkshire-Hathaway/d7c1206a7ac2405ca58abc0667ae43e1/57/0">AP Photo/Nati Harnik</a></span>
</figcaption>
</figure>
<h2>Turbulence ahead</h2>
<p>In the long run, this approach is likely to produce better results than trying to beat the market – which <a href="https://www.investopedia.com/ask/answers/12/beating-the-market.asp">even pros</a> tend to have a hard time doing.</p>
<p><a href="https://www.cnbc.com/2017/10/03/after-winning-bet-against-hedge-funds-warren-buffett-says-hed-wager-again-on-index-funds.html">Billionaire investor Warren Buffett</a> demonstrated this by easily winning a bet that a simple S&P 500 index fund could beat a portfolio of hedge funds – <a href="https://www.investopedia.com/articles/investing/042015/10-most-famous-hedge-fund-managers.asp">supposedly the savviest investors</a> out there, at least judging by the high fees they charge.</p>
<p><a href="http://jasonzweig.com/a-note-on-benjamin-graham/">In the words</a> 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. </p>
<p>Trying to outsmart the market is <a href="https://ssrn.com/abstract=1622184">akin to gambling</a> and it doesn’t work any better than playing a lottery. Passive investing is admittedly boring but is a much better bet long-term. </p>
<p>But if you follow these guidelines and fasten your seatbelt, you’ll be able to ride out the current turbulence. </p>
<p>[ <em><a href="https://theconversation.com/us/newsletters?utm_source=TCUS&utm_medium=inline-link&utm_campaign=newsletter-text&utm_content=expertise">Expertise in your inbox. Sign up for The Conversation’s newsletter and get a digest of academic takes on today’s news, every day.</a></em> ]</p><img src="https://counter.theconversation.com/content/122003/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>Alexander Kurov 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.</span></em></p>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 UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/926552018-04-10T10:39:02Z2018-04-10T10:39:02ZStock investors on higher floors take more risks – here’s why<figure><img src="https://images.theconversation.com/files/213944/original/file-20180409-114092-5pnx2l.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Do Wall Street's high-rises fuel risky behavior? </span> <span class="attribution"><span class="source">ErickN/Shutterstock.com</span></span></figcaption></figure><p>Stocks have been on a bumpy ride lately as concerns over a trade war prompt investors to rethink their appetite for risk.</p>
<p>But what prompts people to take risks in the first place? A <a href="http://psycnet.apa.org/record/1959-03029-001">desire for wealth</a>? Fear of failure? <a href="http://www.jstor.org/stable/1420596?casa_token=A0JtZ9aiF6cAAAAA:q-iYJB8Y2dMZALZ6EduGDSi9UCjL16oF6pi0f2fPOp8L6FnWas6KiQfmfKiw0qpwhcJ6Mzc71vclD3JhoQonxf_vV9T3VnBvyhnKiD1GVtm6cq43Q4ZY">Personality</a>? <a href="http://psycnet.apa.org/buy/1999-13573-004">Gender</a>? <a href="http://theses.ubn.ru.nl/bitstream/handle/123456789/4908/MTHEC_RU_Floor_van_Dorresteijn_s4208943.pdf?sequence=1">Age? Education? Race?</a> </p>
<p>While studies have found that each can play a role, research <a href="http://onlinelibrary.wiley.com/doi/10.1002/jcpy.1024/abstract">I recently conducted</a> with colleagues found another surprising factor: their location inside buildings, specifically their distance from street level.</p>
<h2>Business and the environment</h2>
<p>Winston Churchill, <a href="https://www.economist.com/news/books-and-arts/21678752-gambler-who-saved-west-mr-high-roller">himself known as a risk-taker</a>, <a href="http://www.parliament.uk/about/living-heritage/building/palace/architecture/palacestructure/churchill/">famously said</a>: “We shape our buildings and afterwards our buildings shape us.” </p>
<p>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. </p>
<figure class="align-right zoomable">
<a href="https://images.theconversation.com/files/213945/original/file-20180409-114098-3d97z7.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=1000&fit=clip"><img alt="" src="https://images.theconversation.com/files/213945/original/file-20180409-114098-3d97z7.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/213945/original/file-20180409-114098-3d97z7.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=747&fit=crop&dpr=1 600w, https://images.theconversation.com/files/213945/original/file-20180409-114098-3d97z7.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=747&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/213945/original/file-20180409-114098-3d97z7.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=747&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/213945/original/file-20180409-114098-3d97z7.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=939&fit=crop&dpr=1 754w, https://images.theconversation.com/files/213945/original/file-20180409-114098-3d97z7.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=939&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/213945/original/file-20180409-114098-3d97z7.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=939&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px"></a>
<figcaption>
<span class="caption">Winston Churchill understood that buildings can affect our behavior.</span>
<span class="attribution"><span class="source">AP Photo</span></span>
</figcaption>
</figure>
<p>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 <a href="https://theconversation.com/architectures-brief-love-affair-with-psychology-is-overdue-a-revival-45896">seems to have mostly been on hiatus</a> since the 1970s.</p>
<p>Despite this, a peculiar group of academics have made great strides in recent years when it comes to understanding human-environment interactions: business researchers. </p>
<p>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.” </p>
<p>For instance, studies have shown that <a href="https://assets.csom.umn.edu/assets/71190.pdf">people are more creative in rooms with high ceilings</a>, <a href="https://www.gsb.stanford.edu/faculty-research/working-papers/can-where-people-vote-influence-how-they-vote-influence-polling">more likely to vote in favor of educational initiatives</a> when they are physically in a school, <a href="https://www0.gsb.columbia.edu/mygsb/faculty/research/pubfiles/3305/Levav%20and%20Zhu%20JCR.pdf">seek more variety</a> when shopping in narrow aisles, <a href="http://www.bm.ust.hk/mark/files/staff/Jiewen/Jiewen-JCR-Aug-2012.pdf">prefer romantic movies</a> in cold rooms and <a href="http://www.esteky.com/uploads/1/1/1/0/11100844/illumination_manuscript.pdf">are more likely to donate to charities</a> in brightly lit settings.</p>
<p>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. </p>
<h2>What causes risk-taking</h2>
<p>So what does all this have to do with risk? </p>
<p>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. </p>
<p>However, research has shown that risk-taking is a function of situations as much as traits. Behavioral economics pioneers <a href="https://www.princeton.edu/%7Ekahneman/docs/Publications/prospect_theory.pdf">Daniel Kahneman and Amos Tversky</a>, 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. </p>
<p>Yet research on the impact of physical environments on risky decisions is scant. Until recently, the only thing <a href="https://scholarcommons.sc.edu/cgi/viewcontent.cgi?article=1003&context=mark_facpub">we really knew</a> 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. </p>
<p>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? </p>
<p>In a series of studies recently published in the <a href="http://onlinelibrary.wiley.com/doi/10.1002/jcpy.1024/abstract">Journal of Consumer Psychology</a>, we found that risk tendencies change drastically depending on people’s location in buildings, specifically what floor they are on.</p>
<figure class="align-center ">
<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">
<figcaption>
<span class="caption">Taking an elevator can be risky.</span>
<span class="attribution"><span class="source">Everett Collection/Shutterstock.com</span></span>
</figcaption>
</figure>
<h2>Going up?</h2>
<p>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. </p>
<p>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. </p>
<p>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.</p>
<p>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.</p>
<p>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 <a href="http://www.statisticshowto.com/order-effects/">“order” effect</a>.</p>
<p>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 <a href="https://www.cornellcollege.edu/politics/Anderson.PDF">previous psychological findings</a> suggesting that individuals who feel powerful are more likely to seek risks. </p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/213946/original/file-20180409-114084-2j6ook.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/213946/original/file-20180409-114084-2j6ook.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=400&fit=crop&dpr=1 600w, https://images.theconversation.com/files/213946/original/file-20180409-114084-2j6ook.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=400&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/213946/original/file-20180409-114084-2j6ook.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=400&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/213946/original/file-20180409-114084-2j6ook.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=503&fit=crop&dpr=1 754w, https://images.theconversation.com/files/213946/original/file-20180409-114084-2j6ook.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=503&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/213946/original/file-20180409-114084-2j6ook.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">
<figcaption>
<span class="caption">‘Elevation’ sickness?</span>
<span class="attribution"><span class="source">AP Photo/Richard Drew</span></span>
</figcaption>
</figure>
<h2>No risk-takers in Kansas</h2>
<p>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.</p>
<p>Loftier office location may be one element that nudges money managers to take unreasonable risks, whether during the <a href="https://theconversation.com/us/topics/subprime-crisis-13708">subprime mortgage crisis</a> in 2008, <a href="https://www.bloomberg.com/view/articles/2017-11-20/bitcoin-has-an-unusual-relationship-with-volatility">historic volatility in the cybercurrency market</a> or in the <a href="http://money.cnn.com/2018/01/16/investing/dow-26000-stocks-wall-street/index.html">record stock market surge</a> that ended in January. </p>
<p>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. </p>
<p>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.</p><img src="https://counter.theconversation.com/content/92655/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>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.</span></em></p>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 UniversityLicensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/942092018-04-04T14:07:06Z2018-04-04T14:07:06ZSpotify goes for gutsy direct listing on stock exchange – here are the winners and losers<figure><img src="https://images.theconversation.com/files/213163/original/file-20180404-189816-1mkg58o.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Spotify goes premium.</span> <span class="attribution"><a class="source" href="https://www.shutterstock.com/image-photo/new-york-city-april-3-2018-1060490090?src=DpbEu1ST8xml0GAzY_o2Xg-2-89">Shutterstock</a></span></figcaption></figure><p>When Spotify finally <a href="https://www.cnbc.com/2018/04/03/spotify-spot-ipo-stock-starts-trading-on-the-nyse.html">went public</a> on the New York Stock Exchange on April 3 as SPOT, it did so in a very unconventional way. For one thing, there was none of the usual fanfare. The CEO didn’t ring the opening bell; in fact, he didn’t even show up. The media covering the event had to talk among themselves as no one from the company was available for interviews. </p>
<p>The initial public offering (IPO) was unusual in other aspects as well. To start with, it was <a href="https://www.investopedia.com/news/what-difference-between-ipo-and-direct-listing/">a direct listing</a>, meaning that the company didn’t issue any new shares. Instead, all the existing shares were listed directly on the exchange for open trading with retail investors but with none of the typical involvement of investment banks. This approach caused some bafflement at the NYSE, as no one really knew how to price the shares. The consensus value was US$132, but after some confusion, the <a href="https://www.cnbc.com/2018/04/03/spotify-spot-ipo-stock-starts-trading-on-the-nyse.html">shares opened up</a> around lunchtime at US$165.90, then closed the day at US$149.01, valuing the company at US$26.5 billion.</p>
<p>By all standards, this was a successful IPO – the company shares rose above their assumed opening price, and demand was strong, even in an uncertain market where recent IPOs have struggled. Let’s take a look at the main winners and losers.</p>
<h2>Winners and losers</h2>
<p>The clear winners are undoubtedly Spotify’s shareholders, consisting of venture capitalists, music companies like Sony BMG, early investors like China’s Tencent, and employees. They saw their holdings grow massively without having to share the gains with the usual gaggle of investment banks and institutional investors. </p>
<p>Others on the winning side were companies contemplating going public, but nervous about the traditional path. Spotify has shown that a direct listing approach can work. </p>
<p>Additionally, Spotify users and customers will benefit as well. Subject to the disclosure rules of the NYSE, Spotify will now be obliged to publish earning releases, insider trading transactions, executive compensation and other decisions which ultimately determine the sustainability of the company. Spotify’s management is therefore submitting itself to the discipline of markets. </p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/213164/original/file-20180404-189813-ttwf2b.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/213164/original/file-20180404-189813-ttwf2b.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=400&fit=crop&dpr=1 600w, https://images.theconversation.com/files/213164/original/file-20180404-189813-ttwf2b.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=400&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/213164/original/file-20180404-189813-ttwf2b.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=400&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/213164/original/file-20180404-189813-ttwf2b.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=503&fit=crop&dpr=1 754w, https://images.theconversation.com/files/213164/original/file-20180404-189813-ttwf2b.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=503&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/213164/original/file-20180404-189813-ttwf2b.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">
<figcaption>
<span class="caption">Spotify employees will benefit, as will customers.</span>
<span class="attribution"><a class="source" href="https://www.shutterstock.com/image-photo/malaga-spain-april-26-2015-smiling-349880507?src=DpbEu1ST8xml0GAzY_o2Xg-2-3">Shutterstock</a></span>
</figcaption>
</figure>
<p>Retail investors have clearly benefited from the IPO mechanics. In a standard book-building process, the initial allocation of shares goes to institutional investors, who can then flip their shares in the secondary market and benefit from IPO underpricing. Since new retail investors have direct access to the shares originally sold, the underpricing proceeds (about US$17 per share) have been partly enjoyed by individual, not institutional, investors.</p>
<p>However, not everyone was a winner.</p>
<p>Investment banks and others that typically benefit from the listing of shares were largely cut out of Spotify’s IPO (although the company did retain financial advisers). By pursuing a direct listing, Spotify probably avoided tens of millions of dollars in direct fees, and didn’t have to give special deals to large investors. True to its Scandinavian roots, Spotify chose an egalitarian route.</p>
<p>Wall Street banks, already nervous about <a href="https://www.investopedia.com/terms/i/initial-coin-offering-ico.asp">Initial Coin Offerings</a> (ICOs), crowdfunding, and other avenues to raising capital, will be nervous about Spotify’s approach to going public. <a href="https://www.nytimes.com/2004/05/10/business/for-google-going-dutch-has-its-rewards-and-its-risks.html">Google tried a similar route in 2004</a> when it tried to sell shares directly to the public through <a href="https://www.wired.com/2011/01/snubbed-by-google-goldman-sachs-friends-facebook/">a “Dutch auction” process</a> and without underwriters. Ultimately, it surrendered to the Investment Banking industry and ended up hiring advisers to help with its IPO. The Spotify IPO marks a new era in IPO underwriting as market participants now have direct access to information about companies that seek financing. Investment banks are no longer necessary. </p>
<h2>What about Spotify itself?</h2>
<p>If the investment banks were the losers and early investors the winners, where does that leave the company itself? We think that Spotify is in a worse position now compared to when it was private. While its IPO has been great for its investors, we don’t think it’s been as good for the company. There are three reasons for this.</p>
<p>First, the company raised no new capital. By listing directly, all the gains went to investors and none to the company itself. By contrast, Alibaba <a href="https://dealbook.nytimes.com/2014/09/18/alibaba-raises-21-8-billion-in-initial-public-offering/">raised US$21 billion</a> and <a href="https://dealbook.nytimes.com/2012/05/17/facebook-raises-16-billion-in-i-p-o/">Facebook raised US$16 billion</a> when they went public. This means that Spotify must rely on existing sources of capital and ongoing operations to fund its growth. Unfortunately, <a href="https://www.ft.com/content/974206c0-2609-11e8-b27e-cc62a39d57a0">it is losing money</a> (it has never made a profit), and will thus need to become more efficient, raise its prices, or both. Without new capital, it will be harder for the company to compete. </p>
<p>When companies go public without raising funds, they usually do it to issue “acquisition currency”, that is, to either make it easier for potential acquirers to buy the company now that it is publicly listed (through a tender offer); or to allow the company to embark on acquisitions in the home market – a stock-for-stock acquisition in the US is only possible if the acquirer’s shares are listed on US markets. In either case, the Spotify IPO marks a new growth strategy that is focused, not on organic growth and innovation, but on combining its platform and customer base with other larger and smaller companies.</p>
<p>Second, and as mentioned earlier, Spotify will now be subject to all the rules and regulations required as a publicly listed company. It will also need to be transparent in its financial position, and subject to much more media, analyst, and investor scrutiny. Management will have to spend more time managing shareholders. This will make the company more transparent, but also less agile.</p>
<p>Third, private companies generally have more freedom to think in the long term. Spotify will now have to cater more to the short-term whims of investors.</p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/213167/original/file-20180404-189830-3upvdi.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/213167/original/file-20180404-189830-3upvdi.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=399&fit=crop&dpr=1 600w, https://images.theconversation.com/files/213167/original/file-20180404-189830-3upvdi.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=399&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/213167/original/file-20180404-189830-3upvdi.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=399&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/213167/original/file-20180404-189830-3upvdi.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=502&fit=crop&dpr=1 754w, https://images.theconversation.com/files/213167/original/file-20180404-189830-3upvdi.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=502&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/213167/original/file-20180404-189830-3upvdi.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=502&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">Daniel Ek, Spotify CEO.</span>
<span class="attribution"><a class="source" href="https://www.flickr.com/photos/leweb3/6482059981/in/photolist-aSNfAR-bD7zhG-aSHRPM-aSHTx4-aVqi3M-bVbiyN-aUcHXK-aSNfWc-aUcHBT-aUcGzi-aUcGTr-aTfLPe-8GkmF1-duyWLh-UZUxjd-UZot7z-gYWzyp-V3P922-UAQPjJ-gYWuGv-aUcHgR-Vc1XX6-V12HWb-TWX5L5-aSJ2pP-aSJhp8-aSHNyZ-aSNhdZ-c86MGq-UWA5v7-U1Ltjt-VesJxB-gYWxm9-VaThHA-aSJ2ui-gYWCsG-gYWBL9-V2L6YB-gYWysN-UYZ1Lq-VfpjKg-TWX5f5-nG5Tnf-V2KTKP-U1Luj4-CeCim-UYVdHQ-UDbkaL-UE7Zjo-V2Hxsi">Official Leweb Photos</a>, <a class="license" href="http://creativecommons.org/licenses/by/4.0/">CC BY</a></span>
</figcaption>
</figure>
<p>The day before the listing, Daniel Ek, one of Spotify’s founders and company CEO, published a blog about the IPO. <a href="https://newsroom.spotify.com/2018-04-02/tomorrow/">He said</a>:</p>
<blockquote>
<p>Spotify is not raising capital, and our shareholders and employees have been free to buy and sell our stock for years. So, while tomorrow puts us on a bigger stage, it doesn’t change who we are, what we are about, or how we operate.</p>
</blockquote>
<p>But as a public company, Spotify will undoubtedly have to change who it is. It will become less flexible and more restricted in how it operates. And, it took on these additional constraints without the benefit of raising capital. While direct listing was a gutsy move that tempered the greed of Wall Street, we are not convinced that it resulted in a net benefit for the company.</p><img src="https://counter.theconversation.com/content/94209/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>The authors do not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.</span></em></p>Spotify chose an unconventional route for its listing on the New York Stock Exchange. But its gutsy move will be a worry for the banks and doesn’t guarantee a net benefit for the company.Arturo Bris, Professor of Finance, International Institute for Management Development (IMD)Michael Wade, Professor of Innovation and Strategy, Cisco Chair in Digital Business Transformation, International Institute for Management Development (IMD)Licensed as Creative Commons – attribution, no derivatives.tag:theconversation.com,2011:article/918742018-02-14T15:18:00Z2018-02-14T15:18:00ZWhy does inflation make stock prices fall?<figure><img src="https://images.theconversation.com/files/206392/original/file-20180214-174982-1obv4hh.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=496&fit=clip" /><figcaption><span class="caption">Even the big, bad Wall Street bull is scared of inflation.</span> <span class="attribution"><span class="source">AP Photo/Richard Drew</span></span></figcaption></figure><p>Stock markets <a href="https://www.nytimes.com/2018/02/08/business/stock-market-activity.html">have been on a wild ride</a> recently, plunging one day and then soaring the next. </p>
<p>Pundits have <a href="https://www.theguardian.com/business/2018/feb/06/stock-markets-dow-jones-five-key-factors">offered many reasons</a> for the biggest stock market swoon in two years. One of the most frequently blamed culprits was the <a href="https://www.theguardian.com/business/2018/feb/08/dow-jones-sinks-again-as-bond-yields-rise-and-higher-inflation-feared">threat of inflation</a>, which loosely means an increase in consumer prices over time. </p>
<p>That threat became a little more real after the latest data, released on Feb. 14, showed <a href="https://www.bloomberg.com/news/articles/2018-02-14/u-s-consumer-prices-rise-more-than-forecast-on-apparel-costs">inflation in January</a> rising more than expected, sending stocks and bonds lower. </p>
<p>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 <a href="https://scholar.google.com/citations?user=1E8KAEsAAAAJ&hl=en&oi=sra">I’ve studied closely</a> – and how it affects markets offers some answers. It also hints that an economic slowdown is closer than you may think. </p>
<h2>What is inflation?</h2>
<p>Inflation is defined as the rate of change in the prices of everything from a bar of <a href="https://www.bls.gov/cpi/questions-and-answers.htm#Question_7">Ivory soap to the costs of an eye exam</a>. </p>
<figure class="align-right ">
<img alt="" src="https://images.theconversation.com/files/205901/original/file-20180212-58324-u6qi8r.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=237&fit=clip" srcset="https://images.theconversation.com/files/205901/original/file-20180212-58324-u6qi8r.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=1229&fit=crop&dpr=1 600w, https://images.theconversation.com/files/205901/original/file-20180212-58324-u6qi8r.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=1229&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/205901/original/file-20180212-58324-u6qi8r.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=1229&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/205901/original/file-20180212-58324-u6qi8r.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=1544&fit=crop&dpr=1 754w, https://images.theconversation.com/files/205901/original/file-20180212-58324-u6qi8r.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=1544&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/205901/original/file-20180212-58324-u6qi8r.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=754&h=1544&fit=crop&dpr=3 2262w" sizes="(min-width: 1466px) 754px, (max-width: 599px) 100vw, (min-width: 600px) 600px, 237px">
<figcaption>
<span class="caption">Better, worse, same? It’s all in the CPI.</span>
<span class="attribution"><span class="source">Mega Pixel/Shutterstock.com</span></span>
</figcaption>
</figure>
<p>In the U.S., we measure inflation using something called the <a href="https://www.bls.gov/cpi/">consumer price index</a>. 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. </p>
<p>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. </p>
<p>Over the previous 12 months, the index gained about 2.1 percent on a nonseasonally adjusted basis, meaning the price of most <a href="https://www.bls.gov/opub/ted/2018/consumer-price-index-2017-in-review.htm">goods and services</a> rose by about that amount on average during the period. Some, such as hospital services, <a href="https://www.bls.gov/news.release/cpi.t07.htm">climbed at a faster pace</a> than the average (6 percent), while other categories rose more slowly or even declined, such as airline fares, which fell 5.1 percent. </p>
<p>Although inflation is <a href="https://data.bls.gov/pdq/SurveyOutputServlet?request_action=wh&graph_name=CU_cpibrief">still fairly low today</a>, this hasn’t always been the case. In 1979, inflation <a href="https://www.minneapolisfed.org/community/financial-and-economic-education/cpi-calculator-information/consumer-price-index-and-inflation-rates-1913">exceeded 11 percent</a>, a trend that persisted into the early 1980s. </p>
<p><a href="https://www.msn.com/en-us/news/other/the-stock-market-is-worried-about-inflation-should-it-be/ar-BBIPsXU">Some observers</a> are now worried it’s about to start accelerating again. </p>
<h2>The present value of money</h2>
<p>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. </p>
<p>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 “<a href="https://www.investopedia.com/terms/p/presentvalue.asp">present value</a>.” 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.</p>
<p>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.</p>
<p>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. </p>
<p>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. </p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/205903/original/file-20180212-58339-8z3dx3.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/205903/original/file-20180212-58339-8z3dx3.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=400&fit=crop&dpr=1 600w, https://images.theconversation.com/files/205903/original/file-20180212-58339-8z3dx3.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=400&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/205903/original/file-20180212-58339-8z3dx3.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=400&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/205903/original/file-20180212-58339-8z3dx3.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=503&fit=crop&dpr=1 754w, https://images.theconversation.com/files/205903/original/file-20180212-58339-8z3dx3.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=503&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/205903/original/file-20180212-58339-8z3dx3.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">
<figcaption>
<span class="caption">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.</span>
<span class="attribution"><span class="source">AP Images for Walmart/Gunnar Rathbun</span></span>
</figcaption>
</figure>
<h2>Inflation’s flip side</h2>
<p>A second way inflation directly affects stocks has the opposite effect. That is, it should cause them to increase in value.</p>
<p>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. </p>
<p>That leads to higher future cash flows and thus a higher present value today.<br>
These two effects of inflation should in theory cancel each other out. And yet stock prices are usually <a href="https://www.usatoday.com/story/money/markets/2018/02/09/treasury-bond-yield-spike-spooks-stock-market-bulls/320946002/">hammered</a> when inflation rises. So what’s going on?</p>
<p>There’s lots of <a href="https://www.marketwatch.com/story/this-contrarian-investment-is-the-best-hedge-against-inflation-2018-02-08">evidence</a>, including my own <a href="http://www.jstor.org/stable/3594994?origin=crossref">research</a>, 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.</p>
<figure class="align-center ">
<img alt="" src="https://images.theconversation.com/files/205846/original/file-20180211-51716-1fmg12i.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&fit=clip" srcset="https://images.theconversation.com/files/205846/original/file-20180211-51716-1fmg12i.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=600&h=400&fit=crop&dpr=1 600w, https://images.theconversation.com/files/205846/original/file-20180211-51716-1fmg12i.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=600&h=400&fit=crop&dpr=2 1200w, https://images.theconversation.com/files/205846/original/file-20180211-51716-1fmg12i.jpg?ixlib=rb-1.1.0&q=15&auto=format&w=600&h=400&fit=crop&dpr=3 1800w, https://images.theconversation.com/files/205846/original/file-20180211-51716-1fmg12i.jpg?ixlib=rb-1.1.0&q=45&auto=format&w=754&h=503&fit=crop&dpr=1 754w, https://images.theconversation.com/files/205846/original/file-20180211-51716-1fmg12i.jpg?ixlib=rb-1.1.0&q=30&auto=format&w=754&h=503&fit=crop&dpr=2 1508w, https://images.theconversation.com/files/205846/original/file-20180211-51716-1fmg12i.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">
<figcaption>
<span class="caption">Stock markets have been a sea of red lately.</span>
<span class="attribution"><span class="source">AP Photo/Sadiq Asyraf</span></span>
</figcaption>
</figure>
<h2>Slowdown on the horizon</h2>
<p>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.</p>
<p>To understand this, we have to consider how inflation varies through the <a href="http://www.nber.org/cycles.html">business cycle</a>, which is a way of measuring the growth of the economy from the beginning of an expansion to the end of a recession. </p>
<p>At the beginning of a cycle, inflation is often low. (It was practically <a href="https://www.thebalance.com/u-s-inflation-rate-history-by-year-and-forecast-3306093">nonexistent or even negative</a> 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 <a href="http://money.cnn.com/2017/12/22/investing/corporate-profits-2017-wall-street/index.html">higher profits</a>, while <a href="https://www.reuters.com/article/us-usa-economy/u-s-jobless-claims-drop-to-near-45-year-low-idUSKBN1FS23K">most people are able to find work</a>. </p>
<p>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 <a href="https://slate.com/business/2018/02/why-rising-wages-scare-the-heck-out-of-stock-market-investors.html">spooked investors</a> recently. </p>
<p>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 “<a href="https://www.investopedia.com/articles/economics/08/1970-stagflation.asp">stagflation</a>,” 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.</p>
<p>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.</p>
<p>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.</p>
<h2>Is the party over?</h2>
<p>Back to the current turmoil. The <a href="https://www.bls.gov/cpi/">latest CPI figures</a> suggest inflation may be accelerating, but it won’t be clear until we get a couple more readings. </p>
<p>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.</p>
<p>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. </p>
<p>This is why a market can appear to be doing great and then suddenly fall at the first hint of inflation.</p>
<p><em>This is an updated version of an article originally published on Feb. 12, 2018.</em></p><img src="https://counter.theconversation.com/content/91874/count.gif" alt="The Conversation" width="1" height="1" />
<p class="fine-print"><em><span>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.</span></em></p>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 UniversityLicensed as Creative Commons – attribution, no derivatives.