What makes prudent stock investors

What makes prudent stock market investors is an old question. On the one hand, our ordinary observation confirms the view that good knowledge about stock market mechanism such as stocks evaluation through calculation of present discounted value of a particular stock matters a lot and that a person with good stock market knowledge in particular and financial economics in general is expected to be a good investor. On the other side of the coin, our observation also confirms that knowledge is not what matters. The testimony to this statement is the debacle in the US stock market which came through financial engineering such as credit default swaps and securitisation that paved the path for securitisation of sub-prime and third class lending and a highly sophisticated  mechanism of risks transferring and sharing which ultimately proved to be a futile attempt.
 Even then our tendency is that knowledge is what ultimately  matters. This is true. However, what kind of knowledge matters is still a matter of dispute. If one claims that good working knowledge in financial economics will make one good investor, then, conversely, it can be argued that this type of bookish knowledge can't make stock market investors winners in the long run. In this sense, ignorance and knowledge hardly makes any difference.
In an article published recently in the Financial Express, Professor Abu Ahmed cited the example of a stock market investor who was trying to sell mutual funds but didn't have the basic knowledge about share evaluation or how to sell shares projecting present discounted value of a stock. The specific example Professor Ahmed presented is one among millions who are also in the same position as this stock investor. So, the conclusion is that it is the ignorance about the stock market mechanism that ultimately led to the crash of the stock market in our country.
 Before hypothesising that lack of good stock market knowledge matters, we can turn our attention to markets where highly educated persons - mathematicians, statisticians, experienced charters, acumen investors - sell and buy stocks.  The US stock market, dominated by QUANTS - an abbreviation used to indicate financial mathematicians, statisticians, and engineers - has witnessed some of the worst stock market debacles in the history including the 1987 and 2008 crashes.
Just before the 2010 stock market crash in Bangladesh, this writer witnessed the foolish behaviour of an educated investor. One of his friends, who studied accounting at Dhaka University, invested nearly Tk 2.0 million. On one occasion, he bought some junk shares and claimed that he would  make  big profits. In the end, he lost more than half of his total investment due to the crash. This is not all. Another person, also from Dhaka University Business faculty, bought a share for Tk 600. After some days the price of the share rose to Tk 725. When this writer advised him to sell the share, he told the writer  "I have got some secret news that from tomorrow onwards the price of this share will cross the Tk 800 mark". His expectation was not realised. Instead, within a few days the price of the share declined below the purchase value.
Until now we have narrated stories of small investors who either have or don't have knowledge about how stock market works to illustrate the point whether it is knowledge that matters in the ultimate.     Now we describe a case relating to a person who is not only a giant investor and consultant but also a pioneer  of modern finance. Myron Scholes, who in 1997 was awarded  Nobel Prize in economics jointly with Robert Merton for inventing unique mathematical method of stock evaluation, founded a hedge fund called Long Term Capital Managemetn (LTCM) with co-founders including the fellow Nobel Prize-winner Robert Merton. But due to 1997 asian financial crisis and 1998 Rusian crisis, the highly leveraged LTCM lost $4.6 billion in less than four months. This failure slapped a big blow to the wholesomeness of financial engineering of which Myron Scholes is a significant contributor. Then, following some episodes of ups and downs, by 2000, the fund was liquidated. The failure of the LTCM led to severe lambasting  not only of finance but also of those who developed these sophisticated models treating human beings as robotic creatures who know only how to calculate numerical values punching on high-tech computers but don't know the simple thing that market is composed of human beings - and not of robots.
The failure of the LTCM was followed by another failure. John Meriwether, a co-funder of LTCM and former vice president and trading partners of Salomon Brothers, founded JMW Partners. In the wake of 2008 financial crisis, the fund incurred 44 per cent loss, and finally, it was shut down in 2009.
These examples highlight the fact that good working knowledge about the stock market doesn't anyway ensure that those who possess such knowledge will display an optimal behaviour that will ensure stable stock market situation. Rather even highly educated investors may fall prey to a foolish behaviour that may cause a big disaster. Unlike in other disciplines such as physics in which strong working knowledge can produce a good physicist, in economics possessing strong working knowledge doesn't ensure that one who possesses such knowledge will be a good economist or good investor. Being a good investor or economist requires something else that is not taught in the economics school or doesn't exist in textbooks.
Greed is not treated in the formal economic models; rather these models hail greed in an unbridled manner. One can examine the extremity of greed in the economic theory and practice just by hearing this flamboyant response from one of the twentieth century's best economists and the guru of conservatives Milton Friedman. A journalist asked Friedman:  "… when you see the concentration of power, did you ever have a moment of doubt about capitalism and whether greed is a good idea to run on?" Friedman replied, "Well, first of all tell me is there some society that doesn't run on greed? You think Russia doesn't run on greed? You think China doesn't run on greed?" This was a very clever  answer in the sense that it diverted the topic that the journalist raised. Friedman started to talk about government and other things that are generally called the trademark of Friedman - the man of money supply. On one occasion Robert Solow explained "whenever you talk about something, immediately Milton turns back to money supply." What the journalist wanted to understand was whether greed is a good idea to run on. This is very crucial.
When Adam Smith mentioned about 'invisible hand', greed enchanted the economists. But now it has gripped the humankind as a whole. Stock market is the best example. The cases we mentioned above illustrate this. What a person should think when he hears a highly educated investor saying that he (the investor) has got some secret news that the price of his share will increase in future? It is not true that he doesn't now how to evaluate shares; rather he is aware of all that but greed  makes him blind and finally he acts like an illiterate person. This is why we maintain that the 2010 stock market crash in Bangladesh didn't happen because a lot of uneducated and illiterate investors jumped into the stock market to make big profits; the crash happened because of the foolish behaviour and attitude of educated investors who acted like a role model for those who hardly ever thought of  investing in the stock market. This is called the crowd effect where the people follow the crowd and not the isolated person. Educated investors created the hype both investing in shares that were total junks and in shares that crossed the sensible limit of overvaluation and  the laymen followed them in the expectation of becoming rich overnight investing in the stock market.
So, what matters? Obviously not the bookish knowledge of finance. What matters is the ability to control greed and not to follow the crowd blindly. Economics is not such a sophisticated discipline that only the trained economists and economics students can comprehend; it is such a principle that can be made  comprehensible even to a rickshaw-puller who might never hear the term 'economics'. The reason is that efficient working of economics depends on the strength of moral foundation. If we can take this lesson, then stock market will work better.
The contributor writes from the University of Denver, USA. [email protected]