Reining in market irrationality

In venturing suggestions on so broad a scale, an individual … can be more radical — in the etymological sense of going to the roots of the matter — more consistent, and more venturesome

Milton Friedman (1959)

Prices fluctuate massively in the stock market. All the changes in prices are not due to changes in fundamentals that underlie the prices of stocks. Some are due to sentiment or irrationality. This is now well accepted. The earlier work on efficient market theory (EMT) had only shown that the financial markets are competitive enough so that there is consistently no free lunch in the stock market for most traders. It is interesting that this proposition is consistent with significant and even somewhat persistent mispricing, and excess volatility in the stock market — thanks to the limits on arbitrage in practice. So, EMT does not hold unambiguously. 

Excess volatility in the stock market can have adverse implications for investors, the real economy and economic welfare more generally. 

It would have helped if investors could get good financial advice at a reasonable fee. But this is not the case. Often, the certification of financial advisors is not credible enough. So, we have a small market for financial advice. And, if the financial advice is credibly good, the fee can be high, which too is problematic. Investors use their own knowledge but this can be inadequate, outdated, irrelevant, or even outright wrong in a given situation. The investors are not at fault; they are just doing what they can. Often investors do not realise the nuances of investing. And this is partly due to the fact that investing looks easy (in a subject like chemistry, people are aware of their ignorance).

Financial advisors have their own difficulties. They need to advise on a market that is driven by sentiment, which is hard to predict anyway. Given that the market runs on sentiment and most financial advisors advise on the basis of fundamentals and sentiment both, no individual advisor can afford to ignore market sentiments. If only there was some coordination between all the advisors and the participants so that everybody could focus on fundamentals alone! But we do not have this. Also, unfortunately the education the financial advisors receive is often not rigorous or comprehensive enough to include, say, financial history, political economy, psychology, and technology and economics.  

Last but not the least, we have the constitutional right to property, and freedom of choice. So, investors cannot be forced in any way to invest or not to invest in a financial product.
 

The consequence of all this is what we see, which is that stock prices can go haywire. Given the above diagnosis, this author provides a three-point policy suggestion. This is more of a correction of the prevailing policy framework than an intervention in the stock market. Considering where we are, the three suggestions here can only be “radical”, which is not to suggest an abrupt implementation. 

First, there is a need to improve the selection of students who are interested in a career in financial advice; they need to be “fundamentals-minded”. It is also important to substantially improve the education, examinations, certification, and the entire process of licensing of financial advisors. This takes care of the quality and reliability of financial advisors. 

Second, it is imperative that the financial advisors are educated to give and are under oath to give financial advice on the basis of the fundamentals alone, and not on the basis of the prevailing sentiment and the expected sentiment in future in the stock market. This takes care of the coordination problem alluded to above. 

Third, it should be mandatory for investors to seek professional financial advice before they act in the stock market. Further, though the financial advice is to be mandatory, investors should be free to choose. This takes care of the respect for private property, and freedom of choice in a capitalist or a mixed economy. Because financial advice is mandatory under the policy suggested, we can have a large enough market so that sound financial advice at a reasonable fee can be a reality.

The price-to-book ratio for the Nifty 50 index touched 3.81 in January 2020. It fell to 2.17 in March 2020. It is now around 4.5; it is around 2 for emerging markets. The entire story could have been somewhat different if investors had sound, credible and economical financial advice. But will the investors actually listen? Consider analogous situations. People do take legal advice and medical prescription seriously. This suggests that people will accept sound financial advice too. The stock market can then move towards unambiguous efficiency. 

The writer is visiting faculty, Indian Statistical Institute, Delhi Centre