Money games

The murky world of finance

Raj Rajaratnam — an MBA from Wharton, the head of the Galleon Group of hedge fund and the richest Sri Lankan — has been found guilty of ‘insider trading’ in the USA. What is revealing from wiretape evidence is how people like Rajaratnam routinely use their network of high flying board members and other functionaries of top rated global companies (like Goldman Sachs, Morgan Stanley, Proctor and Gamble, McKinsey and Intel) to get insider information about impending business deals (before these become public knowledge) which help them to make huge profits or avert losses.

The efficient market hypothesis says that in a well functioning share market, market price of shares would immediately reflect any publicly available information. This implies that no one can consistently beat the market and make profits in a sustained manner by day-to-day purchases and sales. Sometimes, he will make money but sometimes he will lose. Of course, someone may be lucky like heads (which a cricket captain calls) may come up for him for a consecutive 4 times in a toss. But his better than average performance in this case has nothing to do with his superior ability.

Therefore, if someone is consistently making a killing in the stock market, either he has ‘insider’ information which other investors do not have or he has been able to get some insight through research which less industrious investors have not been able to or he is plain lucky. Though diligent research does help (since everyone cannot have equal access to such research) people with insider information (which is not legally permissible) will always attribute his superior performance to his better research team. That is precisely what Rajaratnam has been arguing in the court which the court did not accept.

The wife of my friend often complains that her neighbour has made a fortune by playing in the stock market which his risk-averse husband is not willing to do. It is better to discount such hearsays. Apart from insider information and luck, it is also possible that the said neighbour has also lost money at times but he does not disclose that unpalatable fact even to his wife.

In the real world, a few people consistently make money in the stock market usually by using insider information until they are caught like Rajaratnam. Insider trading is widely prevalent everywhere. A much larger number of investors try their luck and lose (by buying late when the price is already at the peak and selling when the price is low). After burning fingers, they settle for safer investments like bank fixed deposits or mutual funds.

Risk-free investments

Mutual fund (MF) investment over a long period of time would typically give higher returns than risk-free investments like bank fixed deposits. This has to be the case. More risky investments must yield a higher average return over a period of time than risk-free assets — otherwise no one will invest in MFs. But the credit for higher returns from MFs does not usually belong to the highly paid fund managers. Experiments have been conducted where a chimpanzee has been given a dart to throw at ‘Wall Street Journal’ stock pages.

The portfolio of companies hit by the dart has been found to do as well as that chosen by professional money mangers. This shows that the trick behind higher average return from MFs basically lies in diversification, rather than anything else.

In other words, it is very difficult to get consistently high returns by buying and selling a few selected shares. Hedge funds which promised and even delivered such consistently high returns for some time eventually turned out to be relying on insider information or indulging in outright fraud.

Bernard Madoff — the operator of the world’s largest hedge fund — is a recent case where he was found to be running a Ponzi scheme under which he was paying returns much above market rates to earlier clients simply by using a part of the money that new investors were bringing to him. This scheme can work only so long as the inflow of fresh funds was greater than the outflow on account of high payout. It can not continue for ever. Incidentally, Madoff was the chairman of Nasdaq for some time — so it was easy for him to make wealthy investors believe in his superior ability to deliver consistently higher returns by using his ‘insights’.

So, the basic lesson for ordinary investors (who do not have rich father-in-laws to bail them out) from all such episodes is that they should invest their money in safe avenues like post office schemes and bank fixed deposits, supplemented by some portion of their portfolio (depending on the individual’s capacity to bear risks and liquidity requirements) invested in mutual funds for a longer time. They should not try to make quick bucks by buying and selling individual stocks by taking ‘expert’ advice from neighbours or even professional money mangers or brokers.

Never forget that professional investment advisors play with other people’s money (they seldom invest their own money unless they have insider information and in such cases they will usually not disclose that information to any one else) and their income mainly comes from commissions, irrespective of whether the investor acting on his advice gains or loses.

(The writer is a former professor of economics at IIM, Calcutta)

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