The idle ramblings of a Jack of some trades, Master of none

Jan 22, 2008

Herds and Markets

After the spectacular equities slump of yesterday and today, and the resulting decrease in the probability of the boy going to Harvard as a fee-paying student (fees to be met by us, his parents, of course), I pondered about herd behaviour, efficient markets and associated paradoxes.

The matter is simple to explain. Most savvy investors would have known early last year that, owing to the inversion of the US yield-curve, the Americans were heading into recession. This is not a foregone conclusion, of course; a better restatement would be that the slope of the US yield curve is a good predictor of future recession in the country (and indeed, owing to the coupling of global economies, the rest of the world as well). Now if the said savvy investors had shorted the market then, they might have panicked a bit when the Dow Jones hit all-time highs in the ensuing months, but - as the yield curve remained inverted - they would have continued to hold to their underlying conviction that the markets would, sooner or later, tank. Rationally, therefore, they should have continued to hold their short positions.

But hang on a tick, as Austin Powers said. If the markets are efficient and are manifestations of all available information, why were they climbing? Did this mean that the market, that is, the vast majority of the participants (you and I and other investors) disbelieved the yield curve theory? In short, there was no impending recession? Well, then, we ought not to have shorted the market as we did. In which case, we'd have ridden up, gloated, and crashed yesterday.

So here's the paradox. If everyone believed that the markets were efficient, nobody would use price-relevant information to time the market, and so the information dispersal would not be complete and so the markets would not be efficient. This paradox has been studied by behavioural economists and other theoreticians, and if they have a solution, I still don't know what it is.

Here's another problem. Much of a working man's wealth (if not locked into his house) is in his pension. A working woman's, too. Most pensions do not allow one to short the market. Of course, if one is invested in an active fund, one would fervently hope that the manager of the fund would be shorting on one's behalf. Clearly, that hasn't happened in the past several months. So all our pensions very likely have tanked.

What's worse is that ostensibly clever investors such as I, diversifying across the world, have been slimed royally by the downturn.

To top it all, we are averse to keeping a cash reserve in the brokerage accounts just for the possibility of buying low when the markets do collapse. After all, who can tell when that will happen? A cash position with a broker would earn almost no interest at all. What a waste of capital in these inflationary times! So now that the Sensex has fallen - and how! - I am unable to buy into the dip because, very likely, by the time I transfer funds into my brokerage, the markets may have recovered...

My son, old buddy, you won't be going to Harvard in a hurry, I'm afraid.


Post a Comment