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D. Murali

THIS is about the very thing you had despised in school: Maths. But do not turn away, because John Allen Paulos can get you interested in the subject with his book, A Mathematician Plays the Stock Market published by Basic Books (www.basicbooks.com). First, however, you need a bit of psychology: "You can be right for the wrong reasons or wrong for the right reasons, but to the market you're just plain right or wrong." That is because the position of short-term investors, as Keynes said, is like that of readers in a newspaper beauty contest, explains Paulos: There, one has to "anticipate what average opinion expects the average opinion expects the average opinion to be... "

To illustrate "common knowledge" — which is "essential to seeing how subterranean information processing often underlies sudden bubbles or crashes in the markets" — the author narrates the story of a village with many married couples, and "the very strict feminist statutes require that if a woman can prove her husband has been unfaithful, she must kill him that very day." A mass slaughtering does occur! Killing husbands is like selling stocks, Paulos would explain, but there is a difference: "Happily, unlike the poor husbands, the market is capable of rebirth."

A section on `behavioural finance' speaks of counterproductive behaviour that can spring from `cognitive blind spots'. "We credit and easily become attached to any number we hear. This tendency is called the `anchoring effect'." Another foible is `availability error' — "the inclination to view any story, whether political, personal, or financial, through the lens of a superficially similar story that is psychologically available." Then, there is `confirmation bias' that makes us "check a hypothesis by observing instances that confirm it and ignoring those that don't." Ask yourself if you tend to gravitate toward those people whose take on a stock is similar to your own. And, do you search vigorously for positive info on your stock?

An inquiry of limited scope can generate deceptive results, points out the author. "If you look hard enough, you will always find some seemingly effective rule that resulted in large gains over a certain time span or within a certain sector."

In such a `reductio ad absurdum' of unfocussed fishing for associations, you may even end up finding that the best indicator of the Sensex has been "butter production in Bangladesh".

Do not bet too much on chatrooms; "a more accurate description of them would be rantrooms", is the author's rant. "Once someone dons a screen name, he usually dispenses with grammar, spelling, and most conventional standards of polite discourse. Other people become morons, idiots, and worse."

There could be discussions that have nothing to do with the stock in question. One that Paulos remembers fondly is about someone who complained his computer didn't work: "It turned out that he had plugged the computer and all his peripheral devices into his surge protector, which he then plugged into itself." Luckily, he didn't plug himself into the socket!

It could be disappointing for chartists that the book looks at justification for technical analysis as `murky at best'. On `resistance' and `support levels' - two important ideas in technical analysis - here's the counter: "The argument for them assumes that people usually remember when they've been burned, insulted, or left out; in particular, they remember what they paid, or wish they had paid, for a stock." We're not elephants, are we?

But there are people who claim to make money using all sorts of strategies. Do they really?

The answer could be yes, says the author, and adds: "The real question is: Do they make more money than they would investing in a blind index fund that mimics the performance of the market as a whole? Do they achieve excess returns? Most financial theorists doubt this." If interested in making a million dollars, knowing "nothing about stock, indices, trends, or dividends", read about the stock-newsletter scam where, like a faith healer, one can take credit for any accidental improvements.

"In the stock market's enduring tug-of-war between statistics and stories, fundamental analysis is generally on the side of the numbers," writes Paulos. "Fundamentals are to investing what marriage is to romance or what vegetables are to eating - healthful, but not always exciting."

That should excite the fundamental-ists. Do you know that the bedrock of mathematical finance and the foundation of fundamental analysis is compound interest? So, "e is the root of all money", where e is for exponentiation. "An old adage has it that those who understand compound interest are more likely to collect it, those who don't more likely to pay it."

Elsewhere, you would see how price-earning (P/E) ratio is similar to BMI (body mass index) that is your weight divided by the square of your height in appropriate units. P/E is a better measure of a company's financial health just as BMI, rather than weight, is a better measure of somatic health. "With discipline you can lose weight or make money."

Do not add weight and lose money!

BookValue@TheHindu.co.in

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