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How Bargains Develop for Investors

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Institutional constraints and market inefficiencies are the primary reasons that bargains develop. Investors prefer businesses and securities that are simple over those that are complex. They fancy growth. They enjoy an exciting story. They avoid situations that involve the stigma of financial distress or the taint of litigation. They hate uncertain timing. They prefer liquidity to illiquidity. They prefer the illusion of perfect information that comes with large, successful companies to the limited information from companies embroiled in scandal, fraud, unexpected losses or management turmoil. Institutional selling of a low-priced small-capitalization spinoff, for example, can cause a temporary supply-demand imbalance. If a company fails to declare an expected dividend, institutions restricted to owning dividend-paying stocks may unload shares. Bond funds allowed to own only investment-grade debt would dump their holdings of an issue immediately after it was downgraded below BBB by the rating agencies. Market inefficiencies, like tax selling and window dressing, also create mindless selling, as can the deletion of a stock from an index. These causes of mispricing are deep-rooted in human behavior and market structure, unlikely to be extinguished anytime soon.