Wednesday, August 10, 2005

Common Man & Uncommon ‘Thoughts’

(Here the common man represents to the guy who tries to beat the market day in and day out.)

Scene Infinity:
Mr. Bull and Mr. Bear are two guys who do the following things with a stock named ‘Prediction, Inc.’. Mr. Bull buys it for Rs. 225, hoping to sell it back at Rs. 240. Mr. Bear goes short on it at Rs. 225, hoping to buy it back at Rs. 210.

Now Prediction, Inc unaware of the positions of Mr. Bull and Mr. Bear just starts swinging. It goes to Rs. 235. Mr. Bull at this point time grows in confidence, for his contention is supported by validity and grows greedy. On the other hand, Mr. Bear loses confidence for now fear reigns higher than Greed and closes his position.

Prediction, Inc got bored and swung the other way. It now quoted at Rs. 215. Mr. Bull realizes that he was greedy and can’t help but close his position. They both leave thinking that they were right in some sense. After all no loser agrees that he is incompetent. If he does that he might be asked to leave the field.

The Problem:
The inherent problem with Mr. Bull and Mr. Bear is that they wanted to seek value (or) make money out of predictions rather than the business that the stock represented. Also not being able to stick to that prediction highlights characteristics of human fallibility (I will discuss that in next paragraph). Everybody when speaking in a group agrees, “Markets, or life for that matter, are anything but predictable”. Yet when left to themselves they try to predict the unpredictable.

‘Only a beggar can stick to their predictions and hold on, not out of confidence but only because they have nothing to lose’. When the elements of apparent ‘real risk’ are combined with irrational action, it eradicates the confidence out of the irrational predictor. (This somehow qualifies as a tautology as far as I am concerned).

The purpose of this write up is certainly not to discuss the stupidity of people, for I am not smart enough to do that, but to discuss the impact this stupidity has on the markets. All the advocates of EMT say that a stock price discounts everything that is known about the company. If they do that or not nobody can say, but I will like to say that they discount ‘predictions’ of this sort into their price, which in effect, nullify all the other factors that can make a difference.

Having said that I will also like to say that I tried to explain the way markets work in a short span of time. But in the long run they work in a completely different way, which I don’t wish to discuss in this write up. May be, the following words will explain much more brilliantly what I may not have been so good at,
“In the short run markets are voting machine, but in the long run they are weighing machine”


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