Ritwik Priya, having decided that he is not going to nitpicky wars with me, has decided to write a series of posts summarizing his text books. But he finds himself unable to avoid taking a swipe at me:
Thus, when Ravikiran asserts here and here that retail investors in India are stupid and hence the EMH may not hold for India, it makes me wonder if he understands the EMH at all. As long as the idiot retail investors in India (or elsewhere) are idiotic in their own randomly distributed ways, the EMH would still hold. The argument is simple – the overestimations of the positive idiots will cancel out the underestimations of the negative idiots. The only problem arises when idiocy is systemic – when idiots make mistakes that are very similar to each other.
The problem with Ritwik is that he balances his undoubtedly sound knowledge of theory with an utter lack of common sense.
Look, the Index was at 21,000 in January and fell to 7,500 yesterday. The reason why it rose to 21K was that people were buying all the way up, and the reason it fell to 7,500 is that people were selling all the way down. The reason to call retail investors as a class stupid is that they are disproportionately and systemically more likely to be buying at 21K and selling at 7.5K. The entire reason why retail investors’ behaviour is a problem is that it is not randomly distributed. But I guess this needs to be spelt out for Ritwik.
The weak form of the Efficient Markets Hypothesis claims that Technical Analysis cannot work. Without getting into the esoteric charts they use, let us see a simple example. Let’s say that a stock is trading at 650 and facing selling pressure. The technical analyst says that the stock has “support” at 500. What he means is that the stock will keep falling steadily till it hits 500, and at that magic number, people will for some strange reason start buying.
Now, either this guy’s predictions and methods are reliable or they are not. If they are reliable, then a lot of people will listen to his advice and sell at any level above 500, which means that the stock will fall immediately to 500. So, there is no way you can make money by shorting the stock, which means that the EMH is valid.
If the guy’s predictions are not reliable, then of course, the EMH is valid.
Of course, the technical analyst can try to make money for himself by keeping his prediction secret and trading based on his methods (instead of announcing his stock calls on CNBC TV18) every day, but what the EMH predicts is that sooner or later, if there is an obvious and easy way to make such stock calls, others will catch on – if nothing else they will just follow what the successful trader is doing.
But all this assumes some amount of sense on the part of traders. My claim is that the stock markets in India have two categories of “investors”. The first category comprises a large mass of idiots who trade based on tips, sell in panic when the the markets are falling and buy in panic when they are rising. They learn nothing and are impervious to logic. The second category is a much smaller group of intelligent investors – there are sub-categories here, but let’s not get into that. The intelligent investors are making money at the expense of the idiots, but contrary to what the EMH predicts, they are not delivering the knockout punch. The EMH says that in a situation like this, the idiots should get bankrupted and eliminated from the market, leaving the intelligent investors trading against each other. My claim is that this is not happening, because of a combination of three reasons:
- The intelligent investors are few in number, and relative to the vast mass of idiots, have less money. According to the EMH, this should not matter as long as the good guys have the right tools to do the job, but ..
- The Indian financial system is not well-developed enough for the good guys to use the right tools
- The idiot investors treat the stock market like a casino – which means that they are risk-loving instead of risk-averse, and are willing to take a risk-discount instead of a risk-premium.
The three reasons are interrelated. Let’s say that right now you think that the market will rise to 12,000 in a year – that’s a cool 50% return, but you don’t have enough money to invest in an index fund right now, so you go long on index futures. That way, you don’t have to put much money other than the margin upfront. This is an example of point no. 2 – tools like derivatives keeping the markets rational. If a sufficient number of people see sense, and decide that whatever the short term fluctuations, the market is bound to rise next year, then that will cause the market to rise right now, and eliminate the arbitrage opportunity. But if for some reason, even this small amount of money does not flow to fight the tide of irrationality (point no. 1) then the few intelligent investors may lose their shirt in margin calls before they are proved right. I believe that a combination of point 1 and 2 (not enough money and insufficiently developed tools) explains in large part why the EMH does not apply in India.
The last point is the most important. I am guessing that the actual percentage of India’s savings that goes into the stock market is very low, and consequently, has scope to vary wildly. People who are risk averse do not invest in stocks at all. Those who do are the kind who are looking to double their money in a month. Just as people do in a casino, they probably lose money. On an average, they probably end up making less than a savings account, but just like in a casino, no one looks at the average return, but get fixated on the big wins in times of booms and big losses in times of busts. Some people probably go bust and commit suicide. But most people, even when they lose significant amount of money in busts, stay away for years and eventually return. They don’t permanently stay away, and they don’t learn to channel their money intothe stock market through intelligent avenues (and earn “just” 15% a year? Bah!) Unless either of these happen, the EMH will not start applying. Treating the market as a casino becomes a self-fulfilling prophecy.
In all this, I am not sure of the role of FIIs. I suspect, with no real evidence, that they actually contribute to increasing the volatility, because their inflows and outflows are determined more by movements in world markets than the state of the Indian economy, and their mandate makes them ask risk-seeking as the retail investors. Their idiocy is at par with, if not worse than those of the idiot investors.
So, here is my 1000+ words on the subject. I have used fewer big big words than Ritwik, but I hope I have made as much, if not more sense.
Not to belabour the point, but can someone go to the second link in Ritwik’s post – the one that goes to How I Manage My Investments and explain to me how Ritwik concluded from that post that I don’t believe in the EMH for India? I mean, I don’t think he even understood that post. No one did. I am not sure I understand it myself.