India Economy

Some misconceptions about stock markets

ALOK RAY | Updated on January 16, 2018 Published on October 09, 2016

Investors should not try to make a quick buck by trading on expert advice from neighbours

The other day, my friend’s wife remarked that Economics is a bogus science. Economists cannot even predict whether the stock market is going to go up or down the next day. She further complained that her neighbour had made a fortune playing the stock market which her risk-averse husband was not willing to do.

I have also heard comments that the claim that India is currently the fastest growing economy in the world is false because if this were true, the Sensex would have been going up and up.

It is true that economists, or for that matter no one, can always predict accurately how the stock market will behave.

Can’t outsmart the market

The efficient market hypothesis says that in a well-functioning market, the price of shares would immediately reflect any publicly available information. Hence, there would not be any scope to make a killing by buying at a low price and then selling at a higher price later. This implies that no one can consistently beat the market. Sometimes, you will make money but sometimes you will lose.

So, if someone is consistently making a killing, he has either ‘insider’ information or he has been able to get some insight through research or he is just plain lucky. For the same reason, it is better to discount hearsays that the neighbour is making regular killings. Apart from insider information and luck, it is possible that the neighbour has also lost money in the market but he doesn’t disclose the unpalatable fact even to his wife.

In the real world, a few people consistently make money in the stock market by using insider information. A much larger number of ordinary investors, after burning fingers settle for safer investments. MF investment over a long period of time would typically give higher returns than risk-free investments like bank fixed deposits. This has to be the case. Riskier investments must yield a higher average return over time than risk-free assets — otherwise no one will invest in MFs. But the credit for higher returns from MFs does not usually go to the highly paid fund managers.

Experiments have been conducted where a chimpanzee was given a dart to throw at ‘Wall Street Journal’ stock pages. The portfolio of companies hit by the dart has been found to do as well as that chosen by professional money managers. This shows that the trick behind higher average return from MFs basically lies in diversification, rather than anything else.

Play it safe

So, the basic lesson for ordinary investors from these episodes is that they should invest their money in safe avenues like post office schemes and bank fixed deposits, supplemented by some portion in mutual funds for a longer time. They should not try to make a quick buck by buying and selling stocks based on ‘expert’ advice from neighbours or even professional money managers or brokers.

Do not forget that professional investment advisors play with other people’s money. They seldom invest their own money unless they have insider information and in such cases they will usually not disclose that to anyone else. Their income mainly comes from commissions, irrespective of whether the investor acting on his advice gains or loses.

Finally, is a booming Sensex a good indicator of a high growth economy? The truth is: a buoyant stock market is neither necessary nor sufficient. Economic growth basically depends on new investment and the productivity of investment. A stock market boom is primarily concerned with rapidly rising prices of existing stocks (in the so-called secondary market). However, to the extent high prices of stocks encourage firms to raise fresh capital (in the primary market) for new investment, it does indeed help economic growth.

On the other hand, stock market bubbles built on fickle foreign flows (not FDI) – which inevitably have to burst – create instability and uncertainty in the economy.

The author is a former Professor of Economics, IIM, Calcutta.

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