In late 2007, the Shanghai stock market was going through a boom. A Professor of Economics was visiting China and there he learnt that everyone, everyone was expecting the stock market to crash after the Olympics in September 2008. In other words, they assumed the market to keep rising like a Diwali rocket till then, and then fall dramatically.
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.
Rediff has put out an informative news item from PTI that helpfully informs us that the Indian stock market will rise over the next 15 years, albeit punctuated by the occasional dips, and that it will breach its alltime high of 21K … sometime within that period. This is very helpful news. Pass it on to anyone who is interested.
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.
These days, one of the great joys of my life is watching the stock markets fall. I don’t get much time to watch TV, but I follow the collapse of the market through the Rediff stocks page. The advantage of this page over other choices is that I get to read the prognostications of the “technical analysts”. Their statements have a zen-like quality to them. For example, at 9:33 AM today, Prakash Gaba, technical analyst has said:
”If the market falls any further, a bounce can be expected”.
Also, going by the evidence on this page, Ashwani Gujral, technical analyst is on CNBC Awaaz all the time. I wonder if he gets time to do his job.