Stock market is random

There are patterns but they manifest themselves over long periods of time, driven by fundamental attributes

Ifthikar Bashir
Srinagar, Publish Date: Aug 13 2018 10:49PM | Updated Date: Aug 13 2018 10:49PM
Stock market is randomRepresentational Pic

I switched on the TV and turned to a well-known business channel. The anchor was analysing the day's movement on the equity markets. She said, 'The SENSEX was up by 265 points today, while the NIFTY was up 92 points. There was no real reason for these moves. Like most days, today was a day of random events on the stock markets. We have nothing else to add, so our channel will be shut till tomorrow morning.

That's what an honest business channel would sound like, but of course, this won't ever happen. The gyrations of the stock markets over the recent months have seen a lot of people hunt for cause and effect. The steady decline over a period, as well as the sudden revival has many different sets of reasons behind them that the talking heads in the business channels promote. But there's a problem, which is that everyone is united in the belief that there are clear and identifiable reasons for everything that is happening. There is reasonable story--actually, many reasonable stories--about why the equities markets are doing what they are doing. For most of the media, there is a narrative that gets built every morning and every evening explaining what happened and what is about to happen. 

Investors too, believe in this whole system. Events happen, and the equity markets respond to it. And every move can be connected to a cause. It's unfair to blame just the business media for it. Finding patterns and believing in cause and effect is an integral part of the human psychology. As a species, we have probably survived and flourished by figuring out how the world works, and being able to anticipate what would happen in the near future. For example, ancient human beings wouldn't have survived if they hadn't associated eating food that smells rotten with falling sick. Figuring out cause and effect is central to dealing with the world. 

However, it's easy to take this too far. Most superstitions are based on seeing too much associations with random events. A black cat crossed your path? Well, there are millions of black cats in the world and they are constantly running around crossing people's paths. Some of these people will randomly have bad things happening to them, thereby strengthening the belief in the superstition. Much of what we believe about investments comes in this category. Someone is managing a mutual fund and takes certain actions. The fund does well. Immediately, we conclude that the fund performed well because of that fund manager's actions. Ergo, he must be a good fund manager, and will continue to do so in the future. But this conclusion may not be correct--we have been fooled. We have been 'fooled by randomness'. 

The other day, I came across the case of an anti-SIP mutual fund salesperson. An acquaintance said that he had just made an investment of a few lakh rupees in an equity mutual fund. When I asked how many months he had done the SIP for, he said that he hadn't made the investment through an SIP. Apparently, the salesperson, who was from the bank where my friend had an account, advised him against it. The salesperson said that SIPs  were only meant for situations when the market was going to perform badly. When it was going to do well, then SIPs are harmful.

The logic is impeccable. It is true that if you start an SIP when the market is doing well, then you make relatively lower returns than you would otherwise have done. On the other hand it is advantageous to invest in SIP when the market is in doldrums because it will fetch higher returns. However, I have a problem with the starting point of the decision-making process, which is that a salesperson from a bank knows how the markets are going to do. Understanding how the market operates is the first important step for an investor.

Most of what happens in the markets is random. We pick up patterns in this randomness and try to draw inferences and make predictions. The central idea here is that there is a lot of randomness in investing and if you try to analyse everything with the assumption that it is not random, then you will not be able to understand what is going on and how to cope with it.

The only way to cope with this is to understand that beneath the randomness, there are patterns but they manifest themselves over long periods of time, driven by fundamental attributes. If you need a reason for every move of the equity markets, then most of the reasons you'll find will be fictional.


(Ifthikar Bashir is a freelance Financial Advisor) 




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