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Stock market & the Greater Fool Theory

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May 30, 2006 12:18 IST

If, as argued last Monday, the efficient market theory does not always work, when markets get over-heated, another, not quite academic, theory comes into play. Even after most participants have recognised that the prices are too high, that they have gone up too fast, and that, therefore, there is an increasing possibility of a sharp correction, they go on buying. (Indeed, most short-term players are trend followers).

The hope is that they would still be able to exit at a profit, because a "greater fool" will come along to buy the shares at an even higher price! This does work so long as the trend continues, but the risk is that the greater fool may turn out to be yourself!

If memory serves me right, it was Peter Lynch, the successful and respected mutual fund manager, who, in one of his books, gave the example of his mother. He says that when the market has been going up for some time (April end?), his mother suddenly phones him to say that she wants to buy shares.

When Lynch asks her "why", the answer is "because shares have doubled in value". Lynch tries to convince her that this is not the best way to make investment decisions, but rarely succeeds. Lynch's mother, and the otherwise sane lawyers and doctors who sold everything to invest money in equities at the height of the Harshad Mehta and Ketan Parekh booms, are often the people left holding the can. We would surely hear many similar stories now, as the tribe of day-traders has grown in population.

One of the more positive fallouts of the recent burst of volatility in stock markets is the evidence of how well the margin systems of the exchanges have worked. There have been no defaults, probably because the exchanges have been ruthless in effecting sales of holdings and liquidating positions, when margin calls were not met.

Indeed, as a risk management consultant, I find the margin system extremely useful to act as an automatic "stop loss". The discipline of stopping losses at predetermined levels, and allowing profitable positions to ride, is the key to consistently successful speculation.

On the other hand, the average trader or player is too anxious to take profits and reluctant to accept losses - hoping against hope that the markets will recover.

Indeed, I find that even professional money managers like banks, fall in the same trap - not so much in their foreign exchange operations, as in their investment portfolios. Stop losses are hit but often not acted upon on the specious argument that the fall is likely to be temporary: if the future is predictable, stop losses should not be specified at all. Incidentally, the world's most successful investor, Warren Buffet, does not believe in them; we should also remember that he welcomes market falls as a buying opportunity!

Still, on banks and their risk management policies for investment portfolios, there is a strong case for the banking supervisor to change the accounting norms. The current rule is that mark-to-market is done on a portfolio basis, but the book values of individual securities are left unchanged. This means that stop losses are often monitored in relation to the book values, which hardly makes sense. While the "cost or market, whichever is lower" is a good principle for valuing inventories of manufacturing companies, surely investment portfolios need to be valued at market prices, except in the case of the portion held to maturity.

The stock market correction has once again brought to the fore one folly of our IPO rules. A certain proportion of the issue is reserved for the "small investor", and is sold below the issue price. To my mind, this obvious arbitrage opportunity is what led to the recent IPO scam in which thousands of fraudulent bank and depository accounts were opened. But this apart, the below market price sales to small investors are indeed a disservice to them for several reasons:

These days most issues are fully, if not over-priced. There is every chance of the investor losing money on the subscription. Many shares are currently below their issue prices.

The only "free lunch" in equity investments is diversification, which reduces risk without necessarily reducing returns. Encouraging individual investors to enter the market directly, not through mutual funds, in effect denies them this free lunch.

It is high time the "favour" to small investors is brought to an end.

At the macro level, the recent correction of equity prices has been a worldwide phenomenon - from so-called "mature" to emerging markets. Will this dampen the "animal spirits" of the entrepreneur, as also the consumer, sufficiently to slow down world growth? Don't rule it out, particularly if interest rates keep going up.
A V Rajwade