M. A.

Faisal Mahmud
faisal.mahmud@at-capital.com

Interim price oscillation and stress make over myopia

In an extremely volatile market like ours, short-term stock trends are awfully used
to control risk and enhance returns. The magnitude of short-term price swings
(upward or downward) is often greater than a stock's appreciation/depreciation for
even a year. As the market is voter machine rather than weighting machine so it is
somewhat impossible to know in advance whether a short-term "dip" will not
become a "plunge," or a short term “rise” will become a “surge”. That’s why it
worth careful attention to the dips and rises and to set limits to how much of a
decline/increase in stock price will be allowed before selling/buying.

Speculation or rumor based trading may not allow us to obtain great return for a
long term. That can work with a good mutual fund (obviously only if PM (Portfolio
Manager) is a good stock player who have a formulated buy/sell discipline along
with good equity research), because the manager performs the necessary buying
and selling while the investor simply a silent partner. Though a person might do well
sitting and waiting for a mutual fund to perform, sitting and waiting for individual
stocks may perhaps disappoint in short run. On average, the “buy and hold”
approach could net an investor market-level returns or slightly better. What's wrong
with that? We must ask ourselves whether that kind of return is worth the risk.

As most of the investors in Bangladeshi Capital market do not have equity research,
they don’t have any formulated buy or sell discipline. Very naturally, when they
notice a sharp price fall or a sharp increment, no matter why, their nervous system
responds and speed up, among others, their reaction time preparing themselves to
either take a long position or flee from the market.

We have seen the wreckage happened in Bangladeshi equity market in 1996, made
thousands of fools (!) left with almost nothing. We do not have unlimited capital
with which to work. Within the limited capital we have to earn in line with the risk
we are taking. For most mutual funds we expect that they will outperform the
market. It’s rational, because if we equally distribute our wealth in each of the
securities (let’s assume no transaction cost) than we’ll get market return or work
with an index fund. There is nothing valiant for a PM to earn a market return. Thus if
the market has larger mutual fund base with efficient management then we can
expect a lower stress in investors’ nervous system, thus alluring them to invest in
long term frame (within predetermined term preference). It will thereby honor us
with stable market.

One fact that has to be dealt with is that a few years ago the typical "trend" of a
stock lasted about 6 months. This was the approximate "central tendency" of the
distribution of trend duration measurements, meaning that some trends were
shorter and some longer. The curve of probability is skewed because sometimes a
stock will trend for well over a year. Recent volatility appears to have shortened the
duration of the typical trend. Even if this were not so, there is no way to know in
advance which stocks will trend for a year or more. Market behavior dominated by
the anticipation of non-random events (insiders, friends, competitors, and other
associated persons and their observers often know how companies are doing before
those companies release public statements, and all these people buy and sell
stock). Thus, changes in the price and volume activity of a stock often precede the
news releases and earning adjustment reports.

1. The market is much more volatile than it has been in the past.
2. The average stock trend lasts less than a year.

Average stock
trends is getting
smaller

The market return pattern is skewed (skew .0086) and kurtosis is high (kurt 3.34)
and volatile at .012. The volatility of the market has increased in 2009 (SD 0.013)
compared to that of 2003 (SD 0.008). The market is still dominated by
unsophisticated retail investors. The retailers switch to low-profile ‘Z’ category
companies’ shares to make a quick capital gain, resulting in ‘intra-day’ volatility in
the market. ‘Rumor-mongers use the troubled time. On the other side, the market
has been experiencing significant flipping of IPOs. Relatively smaller issues are
normally flipped more than larger issues and institutional participation in the new
issue accelerates flipping that contributes to market volatility. It’s true that in the
absence of price volatility, potential investors lose interest to participate in the
stock market. But it is important for the concerned authority to intervene when the
market experiences excessive volatility since high volatility can lead to a general
erosion of investors’ confidence and flow of capital away from the equity market.

No system designed to protect investment capital while investing in individual

stocks can ignore the potential long-term plunges of the market. There is no way to
know in advance that a "dip" is really not the first leg of a "plunge" (if the dip
continues, it becomes a plunge). Since an investor cannot always say, "this is only a
dip, so I will keep holding," limits must be set on how negative stock behavior will
be allowed. Likewise emotional balance is also mandatory in case of setting buying
point. This means that though it may sometimes make sense to hold a stock for a
year or longer, it is also reasonable to hold many positions less than a year in order
to reduce exposure to risk. However, over reaction will allow ‘Rumor-mongers’ and
Gamblers to make quick money. On the other side it can make thousands of people
left with a bag with no coins. So keeping “emotion” under control is getting more
important than any time ever!