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Buy stocks! Buy stocks?

Jul 19, 2005

Wait! Don't get excited! This is not what we are asking our readers to do now when the markets have been moving in a danger zone, much faster than is warranted by fundamentals. But, in these times when Indian equities have regained their 'lost' sheen and have reached higher levels, as has been seen in the past, there are reports doing rounds in the media asking investors to buy into anything as the 'future looks bright'! Now, what should a retail investor do if not give in to the 'strong' arguments that follow such predictions? Here's a way out. Stop listening! Do not let a misguided step turn your investment venture into a speculative misadventure. In the backdrop of the buoyancy in Indian markets, we conducted a poll on our website asking our readers whether their allocation to equities has increased, decreased or remained stable during the past two months. And the response was alarming! Out of those who participated in the poll, 52% indicated to have increased their allocation to equities in the past two months. Of the remaining, while 26% voted that they have reduced their exposure, the remaining voted for their allocation remaining stable.

While we have reiterated in the past that investors need to practice utmost caution in these times, especially if they are too dependent on the broker community for 'tips', the current situation prevailing in the market brings us again to the battle that has been raging between the 'non-terminating bull market theory' and 'rationality in investing'! Let us understand this by beginning with a simple quote and understanding how a basic principle of economics has been so often misused in the world of investing.

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

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 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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