The professor was amused that no one had reasoned backwards from there. Everyone expected the market to fall in September. So, what would happen in August? Wouldn’t they think, “Hey, I don’t want to get too greedy. I know that the index will rise another month, but what if it suddenly starts falling  and I am caught short? I had better sell right now and book my profits.”

Now, if many people think so, prices will fall, not in September, but in August. But if everyone knows that everyone else is thinking that way, why would they wait till August? Won’t they start selling in July? And so on, by induction, if people expect the market to tank in September, prices should fall right now.

This is what traditional economics suggests. Behavioural economics argues that the professor’s analysis is incomplete. Obviously, not everyone will decide to sell in August, but some people will. What will happen in the market is the classic battle between greed and fear. Some people, overcome by greed, will hold on in the hope of making even more gains, while some people, overcome with fear, will sell. At some point, fear will overcome greed and the market will crash.

So, behavioural economics is useful. It helps us understand why booms and busts occur. But is it useful in the sense that we can do something about it? One way of doing something about it is to profit from our knowledge of behavioural economics. If I can use this new science to predict exactly (or even approximately) when the boom will turn into a bust, I can keep buying just before that point and then sell. If I can do that, then I can make consistent supranormal profits, and the Efficient   Markets Hypothesis would have broken down. Of course, I will also need to keep my knowledge and actions secret from others, because if everyone starts doing what I did, then my knowledge will be useless.

So, when Ritwik says that behavioural economics will falsify the EMH, this is what he means (or should mean). But is it anywhere close to doing so? While it is good at explaining, in terms of actually predicting, it is no better than a trader’s gut feel. This is not surprising. Even after the  behavioural scientists have a working theoretical model of a human society (which I doubt they have yet)  they will need to come up with the data that they can feed into their models.  This data is inevitably voluminous and difficult to obtain.

So, instead of asking me whether scientific models have to be perfect to be used,  Ritwik needs to explain what stage of usefulness his preferred models are at.  Right now, we have some theories that have been validated by surveys of actual human behaviour, and through experiments performed in controlled laboratory settings. Occasionally, we have seen them validated in pilot studies, but even here, conditions are fairly controlled.  What we need to see is a working model of human and social behaviour that puts together most of the theories that we have come up with.

In other words, what we have right now is equivalent to a situation where Newtonian laws of Physics are being developed, and it is being claimed that developing complex machines is a trivial step that can be left as an exercise to the reader. Yeah right. Someone just has to put together Newtonian mechanics, corrections to them that need to be performed when you apply coefficients of friction and air resistance, the laws of electromagnetism that will come into play when electricity is involved, and then predict how the machine will behave in real life. None of these will require Einstein-like genius, but it does require a lot of work. Engineers these days can put together a machine entirely on computer and be able to predict very well how it will behave, but it has taken a couple of centuries of trial and error to get to that stage. It takes astonishing hubris to claim that we have reached that stage with a science that has developed in the past 3 decades and which deals with systems as complex as the human mind and human society.

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:

1. 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 .. 
2. The Indian financial system is not well-developed enough for the good guys to use the right tools
3. 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.