Sunday, April 30, 2006

Of Men and Mania

All such inexplicable movements in prices start
due to some fundamental reasons. If the momentum is
sustained for quite some time than that alone becomes
reason for further rise. To explain this I would compare
greed and fear as accelerator and break for the price
movement. When price moves upwards for quite some time the
public starts getting news of people who have made
themselves rich in a short period of time. The lost of
opportunity pinches everybody. If the rally is sustained
further than the fear of losing the chance to be a part
of party overcomes the fear of loss. This is how the
breaks start functioning as accelerator and the prices
rise to astronomical proportions. However in real life
a car without break can not go ahead indefinitely. A
crash is due and it comes as surely as night after
day. After the crash the panic grips the crowd and all of a
sudden negative news start flowing from all sides. A
crash of a fellow driver(read NASDAQ) forces up to
check the speed and grope for breaks. The crash brings
prices not only back to the intrinsic values but often
brings them even lower.

The lesson we can learn from these are many.

1. If something rises well above its intrinsic price then there is no limit where it will end but that it will end is sure. However you can not go short if you see an stock quoting much
above it's real value. If that price is not high enough,
than even two times that price isn't.

2. You can not buy something just after the crash when this
return to their real prices as the momentum generally
takes the prices to opposite extreme. Wait while sense
returns to the sensex.

3. You can not time your entry and exit in such conditions as all forecasts are based on reason and this is by definition rare element
at such times. That means even if you save yourself
from the irrationality of mob, to forecast on the basis
of their rational behavior is foolish.

4. You can not afford to be overconfident about your
abilities as everybody among the crowd is feeling in the
same way. Like everybody thinks that he will be able to
sell of quickly if a crash comes.

5. You can think of your actions as pretty reasonable but even the
reason wears rosy colors in its eyes. All the public and
media is euphoric at such times. The news, forecasts, analysis and even warnings wear same color at such times. And lastly you can not say that you will plan your
action when such a thing comes but it never tells you of its arrival till such day when you realize that you have brought Wipro at 9500, Zee at 2000 and have no option but to wait and curse your luck.

Reference: Charles Mackay's Extraordinary Popular Delusions and the
Madness of Crowds John Kenneth Galbraith's The Great Crash, 1929 Charles Kindleberger's Manias, Panics, and Crashes

Posted: Dec 4, 2000

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