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Rationality in investing? - Views on News from Equitymaster
 
 
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  • Jul 11, 2003

    Rationality in investing?

    The result season is back and so is the time for speculators to play on stock prices. A glance at the way software stocks moved up on the bourses yesterday after Infosys announced an upward guidance is a case in point. The software story that had been written off post April 10, 2003 seems to be turning back. While Infosys beating expectations meant good fortune for the sector as a whole, once again we saw software companies with poor past track records see their prices shoot up by amounts that would put even Infosys to shame!

    Irrational walk up Dalal Street!
    (Rs) On 9th July'03 On 10th July'03 Gain
    Visualsoft 133 159 19.5%
    Mastek 279 321 15.1%
    CMC 435 487 12.0%
    Hexaware Tech 119 135 13.4%
    Sonata Software 14 16 14.3%

    Now, as we move forward on our journey of providing you with analyses of these results, we take some time out to talk (or discuss) about a topic that is generally relegated to the backseat when it comes to investing in the stock markets. And we, as investors, end up blaming the markets and the mechanism for our misdeed of mixing emotions with investing. This might turn out to be a story with a serious note. So, let us start with some humor that mocks at one of the most cherished (by economists and academicians) principles of economics.

    ‘How many economists does it take to change a light bulb? Eight. One to change the bulb, and seven to hold everything constant.’

    This humour is ‘inspired’ by one of the most important assumptions in economics – ceteris paribus, meaning all other things held constant. Using the ceteris paribus assumption is important because, with it, we can clearly designate what we believe is the correct relationship between two variables. An economist, for example, might say: “If a price of a good decreases, the quantity demanded or consumed of that good increases, ceteris paribus.” This means if the price of Pepsi-Cola decreases, people will buy more of it, assuming that nothing else changes.

    Now arise some concerning questions – Why would economists want to assume that when the price of Pepsi-Cola falls, nothing else changes? Don’t other things change in the real world? Why assume things that we know are not true? Economists argue that they do not specify ceteris paribus because they want to say something false about the world. They want to (they say) clearly define what they believe to be the real-world relationship between two variables.

    This contradictory assumption of ceteris paribus, thus, gives rise to another underlying assumption of ‘rationality in economic thinking’. People (economics assume), religiously, follow the assumption of ceteris paribus to make rational decisions and hold rational expectations. Believing that things would not change in the future, they decide the course of action for their present based on what had happened in the past.

    People often have misconceptions of chance. Investors, for example, may extrapolate from a stock’s or a mutual fund’s two successful years of beating the market to assume that it is the ‘hottest’ story around, or the next big thing! What they ignore here is the possibility of regression to the mean. A flagrant example of this flaw in rational thinking has been the dotcom bubble. Based on Moore’s Law, till the middle of 2000, IT firms and their customers thought that everything in the IT industry would continue to grow exponentially – be it the scope of IT and the number of clients. And this ‘doubling’ actually started to happen – eyeballs doubled, so did venture capital, so did bandwidth and, of course, so did share prices of IT stocks. And India was a very integral part of that ‘doubling syndrome.’ The table below would be sufficient enough to make out the ‘frenzy’ that had caught the investors in Indian IT industry during the boom.

    The (more than) doubling syndrome!
      Avg. Price
    (FY99)
    Avg. Price
    (FY00)
    Change in
    Price
    Avg. Price
    (FY03)
    Change in
    Price
    Infosys 3436 9750 183.8% 3923 -59.8%
    Wipro 2563 5311 107.2% 1456 -72.6%
    Satyam 487 3993 719.9% 233 -94.2%

    Warren Buffett once remarked, “It is only when the tide goes out that you can see who is swimming naked.” And this has been proved time and again by companies that have continued, and are continuing, to grow despite tough economic situations surrounding them. When industries grow, benefits accrue to both good and bad companies. But as times get tough, and as the real test of companies’ strength begins, grain can easily be differentiated from the chaff. While investors have behaved irrationally (sad, but that is true!) at more times than one, those who have set their faith in fortunes of quality companies have seen their investments multiply, and would continue to do so. And if enough investors form their expectations rationally, the effect may be the same as if everyone does. And nothing can be better than that for investors and markets. But till the time this becomes a reality, rationality will continue to be an issue to contradict.

     

     

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