When Markets Go Mad

If you want to be a serious investor, start with a serious study of market history. It will surprise you how risky equities are, says Debashis Basu

In the third week of May, thousands of housewives, college students and new part-time traders felt a rude shock. As the Sensex collapsed by over 2500 points over 10 days, there was bewilderment and panic all round. ‘What was wrong? Why was the market behaving like this?’ was the mute cry. After all, it was supposed to only go up and if it did come down, it should have been only a soft decline before another inevitable rise started.

Those who have been in the market for at least a decade should not have been surprised that the general expectation of how markets should behave was wrong. The answer to why the market was ‘behaving like this’ is secondary. The first thing to understand and accept is the fact that markets always behave ‘like this’. Benoit Mandelbrot, who invented an entire field of mathematics, calls it The Misbehaviour of Markets and has written a book with the same title. Newcomers learn of such unexpected misbehaviour at their own peril and cost through experience. A cheaper way is to study some real history of the markets. That history is littered with booms and busts. This is not what financial theory teaches you. This is not what brokers tell you. Mutual funds, which make a percentage of the amount you put into the fund, are usually happy to present the sunny upside in equities.

One of the ways to figure out whether the market movements are “normal” is to take recourse to statistics. Using statistical tools financial theorists have examined whether market prices are “normally distributed”. The results are interesting. There are too many days when the market goes too much to one side, than what statistical theories of “normal distribution” would imply. According to Mandelbrot:

  • If the market followed a ‘normal’ pattern based on statistics over the last century, there should be 58 days when the Dow moved more than 3.4%. Instead, there were 1,001 such days.

  • Similarly, as per the “normal” assumption of Wall Street there would be six days of index swings beyond 4.5%. In fact, there were 366.

  • Index swings of more than 7% should come once every 300,000 years. In the 20th century there were 48 such days. In India it has happened twice in two years.

    The normal market movement theory is flawed, as anyone who lived through “the booms and busts of the 1990s can now see”, says Mandelbrot. Indeed, this 81-year-old founder of fractal geometry goes on to say that the entire field of investment analysis is founded on a few shaky myths such as market moves are normal and random. The result of following such myths can be quite devastating – like the shock from the recent sharp market decline. According to him, accepted wisdom substantially underestimates the potential for loss when markets go down. What do you need to know to deal with the sharp rises and declines that markets undergo periodically? According to Mandelbrot we need to know the four ways markets differ from popular perception.

    Markets are Risky:
    They are much riskier than most imagine – the recent decline drove home this point.

    Markets move in Streaks:
    Contrary to the accepted wisdom, big moves are often followed by big moves. There are long streaks – witness the continuous rally since October last year.

    Behaviour can Override Fundamentals:
    Markets are driven by the actions of people, not by fundamentals alone. The collective mania of foreign investors followed by locals piling into the Indian market drove it to peaks in 1994, 2000 and 2006.

    Markets Mislead:
    Investors love to find patterns and correlations. These work for a while and then suddenly break down with a severe force. Markets love to surprise.
    In short, frightening declines like we saw in mid-May are not rare. It has happened in 2000 (dotcom crash), 2001 (9/11) and 2004 (after the general elections). That’s just six years of recent history. The reasons were different each time!

  • Additional Readings:
    Additional Reports:
    Off-Topic Readings:
    Parting Thought:
    • You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. – Warren Buffet
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