The Hindu Business Line : Surviving the stock market

Harish sat on the parapet lining the sea-face on Marine Drive. It was high tide and the waves were dashing against the rocks below. He could feel the restless motion of the waves. It was 9 pm. He knew that it was time to get up and move towards the Churchgate station. But he couldn't muster the will. He continued to stare into the dark sea. Perhaps, it would reveal a solution.

His thoughts were interrupted by a voice from behind, "Hello there. Don't tell me it was yet another bad day at the stock markets. You are becoming a part of the Marine Drive landscape these days." It was his schoolmate, Viju, out on his evening jog.

Harish was glad to see his friend. "I seem to be one of the unluckiest people around. The stock that I buy inevitably crashes. And if I go short, the price moves up the next day. Nothing I do turns out right."

Viju could see that his friend wanted to talk it out with him. He sat down next to him, grimacing at the garbage that had collected around the rocks. "What happened this time? Last time you had bought Morarka Finance at Rs 35 just because your broker had said that it was going to hit Rs 50 and ended up sinking Rs 5 lakh in the deal."

"That episode taught me not to follow tips blindly. I had resolved to research a company thoroughly before investing in it. So I bought a computer, got an Internet connection and sat up till 1 am doing my research."

Viju struggled to suppress his smile at this picture. "Bravo! So what did your research throw up?" "I zeroed in on Modern Steel. Great company, EPS of Rs 24, PE multiple of just 2, book value of 75. It makes steel. What more can you ask for?"

"So what went wrong?" asked Viju.

"The usual. I bought 2000 shares at 76. Now the price is at 57."

"I don't get the point. If you are convinced about the fundamentals of the company, all you have to do is to hold on," said Viju, looking puzzled.

"I need to raise cash urgently because Sheela has decided that she can not wait to change the tiles in the kitchen. Once more I have to book a loss. This is so demoralising!"

Viju was at a loss for words.He struggled to come with something pertinent to say. "So you have broken the rule No. 1 of the guidelines that I gave two years ago. The money deployed in trading should only be the surplus money after accounting for daily needs and unforeseen emergencies."

Random walk theory

"Yes, I have," said Harish. "It is all the fault of the market. It is going up, up and away. But whichever stocks I buy or own does a Rip-Van-Winkle act. Is there anyway that we can better the market? There seems to be absolutely no logic in the market."

"Have you heard of Burton Malkeil, my friend? Your ideas concur with his. He said that the past prices or past history have no effect on the future movement of the stock. The price reacts as news pertaining to the stock percolates in to the market. The stock prices are supposed to be taking a random walk. He said that timing the market and trying to beat the market using fundamental or technical analysis is futile. If any one does manage to better the market, it is due to sheer luck" Harish brightened up, "That is precisely what I think too. Now that you tell me that others think likewise, it is definite that all this research is leading nowhere. I think I will sell my computer and give Sheela the money to buy her lavender tiles." Harish got up to leave.

Viju put a hand on his friend's arm, "Not so fast. The Random Walk Theory was propounded thirty years ago. Individuals had limited access to information then, which made outperforming the market almost impossible. But with the advent of the Internet and online trading, information is available to all investors almost free of cost. Transaction costs too have dropped significantly now.

Non-random walk theory

There is another school of though that reflects the thinking of the present generation more accurately called the Non-Random Walk Theory. This has been put forward by Andrew Lo. Lo contends that stock prices are not moving in a random fashion. There is an underlying trend that can be predicted. But to generate good returns, investors need to keep doing research. An interesting point on which Lo stresses is that investors and fund managers need to constantly innovate."

"I don't get it," said Harish. "Why innovate in making investments?"

"Investing is like any other enterprise. Just like the owner of a shop needs to change his merchandise and marketing strategies according to the changing needs of the customers, an investor needs to keep innovating to stay in line with the market conditions.

For example, between 1993 and 2003, the Indian equity markets moved sideways. A buy and hold strategy would not have helped in the period. Churning a part of the portfolio, buying in lows and selling near tops would have worked wonders with the portfolio returns in this period.

"But what about my bad luck?" asked Harish.

"It is all a matter of mindset, my friend." Said Viju getting up. "Even if you get five calls wrong, if the sixth call is right, the profit from one trade will compensate for the previous losses. The trick is to exit a loss early. Ability to be prepared for the worst at all times is the key to survival in the stock market. Be ready to take small losses, the large profits will definitely follow."

Harish and Viju started walking towards the station. Harish murmured to himself, "I will try harder, do more reading and persist. Can't give up so soon. I will convince Sheela that pink tiles are not so bad after all."

Racy@theHindu.co.in

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Surviving the stock market