Examination of Efficient Market Hypothesis in Indian Stock Markets and behavioural patterns of Institutional and Individual Investors in India

By

SHRUTI JAIN

2006

A Dissertation presented in part consideration for the degree of

MA Finance and Investment

ABSTRACT
Over 5 decades a lot of body of evidences have claimed that stock markets are efficient and it is not possible to beat the market consistently. In recent years, however, financial economists have increasingly questioned the efficient market theory. Market efficiency has an influence on the investment strategy of an investor If market is efficient, trying to find undervalued and overvalued stocks and trying to beating the market will be a waste. In an efficient market there will be no undervalued securities offering higher than deserved expected returns, given their risk. On the other hand if markets are not efficient, excess returns can be made by correctly picking the winners. This study examines the efficiency of Indian stock markets and shows that Indian stock markets are not completely efficient. There are existence of mispriced securities and opportunities for investors to outperform the market. As against many claims that it is not possible for any Mutual Fund to beat the market consistently, this study shows that, in India, active funds exist that have beaten the markets consistently. Behavioural finance is also important in making investment decisions in India and market participants are prone to irrationalities like herding behaviour, greed, relying too much on current information that causes market inefficiency and prices of securities to deviate from their intrinsic value. The study also outlines how investors can identify good investment opportunities.

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TABLE OF CONTENTS

List of figures. List of Tables..

vi vii

ACKNOWLEDGEMENT....

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CHAPTER 1: INTRODUCTION 1.1 Background of Indian stock markets... 1.2 Rationale of Research and Gaps in Existing Literature. 1.3 Aims and Objectives of the research. 1.4 Research Questions and Propositions.. 1.4.1 Research Questions 1.4.2 Research Propositions 1.5 Topics Covered 1.6 Summary of this chapter....

1 1 3 5 6 7 7 8 9

CHAPTER 2: LITERATURE REVIEW. 2.1 Introduction. 2.2 Efficient Market Hypothesis. 2.2.1 2.2.2 2.2.3 2.2.4 Implications of EMH... Supporters and Critics of EMH... Behavioural Finance and EMH EMH and Investors strategy of Investment or Speculation

11 11 11 13 14 26 31 34 35 35 36 40

2.3 The Behaviour of Institutional Investors. 2.4 EMH in Indian context.. 2.4.1 Introduction.. 2.4.2 Studies on Indian Capital Markets in context of EMH 2.5 Markets are Efficient or Inefficient? Truce between the two?.............

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CHAPTER 3: METHODOLOGY 3.1 Introduction. 3.2 Qualitative Research and Quantitative Research 3.3 Research Map. 3.4 Research Methods. 3.4.1 Secondary Research. 3.4.2 Primary Research. 3.5 Methodology and Data. 3.5.1 Methodology Framework 3.5.2 Research Setting, Procedures, Participants and Materials... 3.5.2.1 Sampling 3.5.2.2 Research Setting 3.5.2.3 Research Participants and Procedures 3.5.2.4 Data Analysis 3.5.2.5 Rationale for interviews for research 3.6 Conclusion

43 43 43 45 47 47 47 48 48 49 52 53 53 59 61 61

CHAPTER 4: FINDINGS AND ANALYSIS OF STUDY. 4.1 Introduction. 4.2 Findings to the Research Questions and Propositions 4.2.1 Why are IIs not able to beat the market. 4.2.2 How can investors identify good investment opportunities.. 4.3 Findings in context with literature

62 62 62 88 94 99

CHAPTER 5: CONCLUSIONS AND LIMITATIONS. 5.1 Conclusions.. 5.2 Limitations of the study and future research...

102 102 104

REFERENCES. LIST OF APPENDICES.. APPENDIX 1. APPENDIX 2. APPENDIX 3.

109 123 124 129 130

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APPENDIX 4 APPENDIX 5 APPENDIX 6... APPENDIX 7...

134 135 140 141

LIST OF FIGURES

Figure 1

Research Map

46

Figure 2

Methodology Framework

49

Figure 3

Data Analysis Model

59

Figure 4

Model of how the pressure is created on Fund Managers

89

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LIST OF TABLES
Table 1 Research Questions 07

Table 2

Research Propositions

08

Table 3

Interviewees profiles

54

Table 4

Interviewees codes

56

Table 5

Interviewee classification

57

Table 6

Findings on Efficient markets hypothesis

63

Table 7

Findings on Information interpretation

68

Table 8

Findings on investment strategy

72

Table 9

Findings on existence of overvalued and undervalued stocks

77

Table 10

Findings on motives for investment

81

Table 11

Findings on behavioural finance

83

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ACKNOWLEDGEMENT
An ongoing work of three months, completion of this dissertation has been a challenging task for me. But all the efforts dedicated to it were worth it. It had been a great learning and enriching experience and I truly enjoyed the entire process. It provided me the opportunity to meet very distinguished and knowledgeable people of the industry.

All this would not have been possible without the help and support of some people. First and foremost, I would like to articulate my sincere gratitude to Ms Alyson McLintock, my supervisor. She has been my mentor throughout the project and her understanding and help made it possible for me to carry out this study. She always took out time from her busy schedule to meet and discuss and give guidance on various aspects of this dissertation. She had always responded patiently to my demanding long emails and steered my work. Her assurance, guidance and valuable advice motivated me in my study and I am really thankful for all the efforts she has put in for making this study possible.

I would also like to thank all the professors who have imparted knowledge of different subject areas during my Masters program, which proved beneficial for this dissertation. Mr. Shahid Ibrahims lectures on Efficient Market Theory and Behavioral Finance were the main source of motivation for this study, which was further extended by other professors.

My sincere thanks to Mr. Arpit Agrawal and Mr. Ashish Maheshwari, without their help I would not have got the opportunity to get the interviews of such knowledgeable people and conduct my research. I would also like to thank all the interviewees for their contributions, without whom, this research could not have been carried out. Their time is greatly appreciated and is vital to this dissertation.

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I must acknowledge as well my friends who assisted, advised, and supported my research, especially Pratik, who helped me all the while and Vishal who proof-read my work and suggested many valuable changes, my sister who gave me motivation and encouragement all the while and also did proofreading for me and my brother who provided his help and fulfilled all my needs while I was working.

Lastly, I owe a great deal to my parents who made it possible for me to pursue my Masters degree. Throughout the period their support, encouragement and trust on me and my work made it possible for me to complete this course and this dissertation. They supported and encouraged me all the while. They met all my needs during the dissertation. At times I was not sure whether I will be able to complete my dissertation, but my mother encouraged me all along and kept me motivated. Her optimistic attitude is contagious. All the while my parents made it possible for me to have the luxury of time to work and gave me encouragement that helped bring this dissertation to a successful completion.

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Chapter 1: Introduction

CHAPTER 1: INTRODUCTION

The stock market appears in the news everyday and millions of people invest in the
stock market daily varying from professional investors to a layman. The investors in the stock market often try to gauge the true share prices of the companies they have invested in or of the prospective investments, and wonder whether these investments are worth the price currently quoted in the stock market. Despite the ubiquitous recommendations of the analysts, investors loose exorbitant amount of money in the stock market. This study endeavours to find out the reasons why the investors in India are not able to perform well in the market and also to unearth ways and strategies with which they can improve their performance.

1.1 Background of Indian stock markets

Amongst the developing countries, India currently leads in stock exchange development and is attracting investments from foreign investors, both large Foreign Institutional Investors and individuals. During last one decade, the Indian financial system has been subjected to substantial reforms with far reaching consequences. These reforms have helped in dramatic improvement in transparency level in financial markets including stock market. The regulatory changes that have taken place during last one decade of financial sector reforms have resulted in financial markets becoming more efficient with respect to the price discovery mechanism and

Chapter 1: Introduction have helped the market to grow exponentially. There have been significant changes in the regulations for smooth and efficient functioning of capital market in the country. The market has undergone substantial change due to introduction of hedging products like futures and options. The concept of developing a large order book in the stock market made the pricing of stocks more accurate and efficient and also resulted in bringing down the bid/ask spread benefiting the investors community as a whole. International investors access to the domestic market has also helped in increasing liquidity. All these helped in better dissemination of information and hence possibly increased the level of efficiency in asset prices (Nath, n.d.).

Indian stock markets are gaining momentum in the world and are the fastest growing markets in the world amongst the developing countries. Between July 1997 and February 2005, the BSE Sensex Index went from 4306 to 10980 and the NSE Nifty index rose from 1221 to 28541. Despite this growth in the market, not much research has been conducted on Indian stock markets and the various ways in which the Indian analysts predict the movements of the Index and determine good investment opportunities. There is also a gap in the literature on Indian stock market as the studies that have been so far conducted have concentrated on quantitative techniques. Behavioural finance has not attracted much attention of Indian researchers and no study has yet made an attempt to study the behavioural patterns of investors and other market participants in Indian stock markets.

Yahoo Finance

Chapter 1: Introduction I have previously worked in a stock broking company in their research department and my work experience has been the main source of interest development in this research area and imparted me immense knowledge about the subject. This in turn has helped me to choose this topic for research

1.2 Rationale of Research and Gaps in Existing Literature

In spite of the conceptual and empirical evidences on the validity of Efficient Markets Hypothesis (henceforth EMH) in Indian stock markets, a critical review of the literature indicates that very little pragmatic attention has been paid to behavioural finance in context of Indian stock markets. Shiller and Thaler (in Anonymous, 2005) assert that research in behavioural finance has important applications. The research can guide in portfolio allocation decisions, both by helping us to understand the kinds of errors that investors tend to make in managing their portfolios, and also by allowing us to understand better how to locate profit opportunities for investment managers. Shefrin argues that financial practitioners must acknowledge and understand behavioural finance, the application of psychology to financial behaviour, in order to avoid many of the investment pitfalls caused by human error. Despite so much effort put in by the investors, it is becoming difficult for fund managers to outperform the market consistently. There are certain irrationalities the institutional investors (henceforth IIs) and individual investors succumb to that cause their performance to topple, which have not been uncovered through any researcher so far.

Chapter 1: Introduction This study, therefore, tries to understand and find out the errors and irrational behaviour that the investors, money managers, security analysts, investment bankers and corporate leaders are subject to in Indian stock markets, which affects their performance in the market. This research also investigates the human behaviour that guides stock selection, financial services, and corporate financial strategy.

Moreover, although a lot of statistical research has been produced to find out if Indian capital markets are efficient, no study has concentrated on finding out what the stock market participants perceive about the efficient markets theory. And only a small number of researches have made an attempt to find out the reasons for why the markets are not efficient. It is important to understand what the market participants perceive because ultimately they make the markets and their perception would have an impact on the efficiency level of the market. Thus, this study has also made an attempt to find out what the market participants perceive about the efficiency level of Indian markets and the reasons for their perceptions.

The rationale of this research is to find out whether it is possible to outperform the market and if it is, then what investment strategies should be adopted by investors, what commonly made errors they should avoid, how they can identify good investment strategies. Concisely, this research attempts to find out ways to make money from the stock markets in India.

Chapter 1: Introduction The key research question that dominates this dissertation, however, is to find out, what actual investors think about the concept of efficient markets and its implications from their experience in the stock markets in India. And therefore this study seeks to take views of experienced investors and money makers in the market, who understand the stock markets.

1.3 Aims and Objectives of the research

This dissertation seeks to research the efficiency level of Indian stock markets and experts opinion on market efficiency, assess the behavioural patterns of market participants as gleamed from a review of the literature, to assist the investors in their investment decisions (in context of Indian stock markets). This research will be of practical benefit to the researcher in her understanding of the markets and for the research department of the company she would be working with. It will also help the investors in identifying the irrationalities committed by them and how can they improve such irrational behaviour and also to understand what investment strategies should be adopted by them, assisting in their investment decisions. It has also made an attempt to fill the gap in the literature and studies conducted on Indian stock markets. The main aim of the research project is to:

provide an evaluative summary of the efficiency of the Indian stock market.

Chapter 1: Introduction present an argument on the existence of overprices and underpriced stocks in the stock market. provide an evidence on whether behavioural finance is important while making investment decisions in the stock markets. identify the strategies for investors to discover good investment opportunities, i.e. how can they make money in the stock markets.

To achieve the ultimate goal, the research is broken down into several objectives. Therefore, objectives of the research project are to discover:

the differences in the efficiency level between Indian stock markets and other developed stock markets (like USA and UK).

what irrationalities investors succumb to that causes their performance in the market to topple down.

why despite all the research undertaken by the IIs are they not able to beat the market?

1.4 Research Questions and Propositions

In order to achieve the research goal it is critical to clarify the key questions for which answers are sought and why are they important. Precise key questions determine the focus and scope of study. It will help the researchers direct the literature review, the framework for study, tools and techniques, and the analysis (Potter, 2003).

Chapter 1: Introduction

1.4.1 Research Questions

Table 1 outlines the key questions that this study seeks the answers.

TABLE 1 Research Questions Question 1 Are Indian markets as efficient as other developed markets like US and UK? Why? Question 2 Is the information that is disseminated in the market interpreted correctly by the investors? Are there smart arbitrageurs in the market who correct any mispricing in the stock and make markets efficient? Questions 3 What investment strategy should be adopted by individual investors? What factors affect their choice of investment strategy? Question 4 What irrational behaviour or emotional biases investors capitulate to that affects their investment decisions and also market prices and returns? Why are IIs not able to outperform the market? Question 5 How can investors identify good investment opportunities? Is technical analysis helpful in making investment decision?

1.4.2 Research Propositions

There are key issues emerging from the literature review of the topic area and previous studies and an examination of these issues have led to the creation of propositions (outlined in Table 2) for this dissertation, which will be empirically tested through the research conduction.

Chapter 1: Introduction TABLE 2 Research Propositions Proposition 1 Complete market efficiency is a utopian idea. Markets cannot be completely efficient nor are they completely inefficient. Proposition 2 Stock markets price the securities correctly in medium to long term. In other words, over a long-term the price of a companys shares reflects its intrinsic value. Proposition 3 It is possible to outperform the market on a consistent basis and skill plays an important role in such performance. The chances of consistently outperforming the market are low, albeit possible. Proposition 4 Most of the people putting-in money in the stock markets are guided by the short-term speculative motives. Therefore, prices of securities often deviate from their intrinsic value. Proposition 5 Behavioural Finance (BF) plays a vital role in understanding investor behaviour and making investment decisions. With the use of explanations on investor behaviour propounded by BF theory, investors can improve their returns in the market.

1.5 Topics Covered

To gain a solid foundation for studying these queries, a literature review will be produced. The academic sphere has produced a plethora of findings on validity of Efficient Market Hypothesis and its implications, behavioural finance and efficiency level of Indian stock markets. This literature will be sufficiently reviewed and assessed throughout the course of this paper. The topics discussed include

an explanation of EMH, the three forms of EMH and its implications; 8

Chapter 1: Introduction an explanation of the behavioural finance theory and its implications on investing; argument on whether the markets are driven by investment or speculation; the irrational behaviour of IIs. an outline of various studies conducted on Indian stock markets in context of EMH.

The debate over whether the stock market is efficient or not is an ongoing one. The key issue remains how to invest in the market and devise strategies to get good returns and identify the mistakes people commonly make in the market and learn from them.

1.6 Summary of this chapter

This chapter gave a brief introduction to the Indian stock markets and the way the markets have been evolving. This was followed by a discussion on the rationale for the research and subsequent presentation of the aims and the objectives of this study. It also outlined the research questions and propositions that will be used to meet the aims and the objectives of this study.

The topic of efficiency level of Indian stock market, application of behavioural finance and behavioural patterns in Indian markets has been approached as follows:

Chapter 1: Introduction The literature on the EMH and behavioural finance and Indian stock markets is reviewed (Chapter 2). The research methods used to answer the research objectives are then outlined (Chapter 3). The authors findings from the research undertaken are presented and there follows a discussion of what these findings mean for stock market participants and their investment strategies and investment decisions (Chapter 4) Conclusion and limitations of the study is presented (Chapter 5).

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Chapter 2: Literature Review

CHAPTER 2: LITERATURE REVIEW

2.1 Introduction The

amount of research on stock markets and predicting the stock prices and the

markets is overwhelming. There are various schools of thoughts on the subject, where on one side there are academics and scholars who can be divided between those who claim that stock prices or their future trend cannot be predicted and others who assert that it is possible to predict the prices of securities or future trend; and on the other side there are investors and traders in the financial markets who strongly believe that it is possible to beat the market and henceforth profit through careful investment strategies.

2.2 Efficient Market Hypothesis

One of the most popular and widely adopted theories, and the most criticised one, in the financial markets is the Efficient Market Hypothesis. EMH was first proposed by Samuelson (1965) and Mandelbrot (1966) and was successively popularized by Fama (1965, 1970) (Mandelbrot and Hudson, 2004; Zheng, 2005). Following Famas work many studies were devoted to examining the randomness of stock price movements for the purpose of demonstrating the efficiency of capital markets. One of the

pioneers of the EMH who has popularized this framework is Burton G. Malkiel

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Chapter 2: Literature Review (Shostak, 1997)2. According to EMH, in context of equity markets, one cannot predict stock prices or their future trends. The theoretical basis of the EMH states that the investors behave rationally and, consequently, they value the securities consistently with their fundamental value.

Proponents of Efficient Market Hypothesis assert that:

In an active market that includes many well-informed and intelligent investors, securities will be appropriately priced and reflect all available information. If a market is efficient, no information or analysis can be expected to result in outperformance of an appropriate benchmark. (Fama, 1965)

The theory purports that there is perfect information in the stock market, which follows that any new information that becomes available to the market will be very quickly reflected in the prices (Fama, 1970). Thus, neither technical analysis (which is the study of past stock prices in an attempt to predict future prices) nor even fundamental analysis, (which is the analysis of financial information such as company earnings, asset values, etc. to help investors select undervalued stocks) would enable an investor to achieve returns greater than those that could be obtained by holding a randomly selected portfolio of individual stocks with comparable risk (Malkiel, 2003).

Work of Malkiel includes Malkiel (1973), Malkiel (1987), Malkiel (2000). See references for detail.

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Chapter 2: Literature Review EMH is endowed with three distinct forms of informational efficiency, namely, the weak, the semi-strong, and the strong form of efficiency. The weak form implies a random walk (meaning stock prices are not predictable and patterns are merely accidental) of some form (part of Famas 1965 definition of efficiency) and that one cannot take advantage of the knowledge of historical price movements to earn superior returns on investments. In other words, technical analysis is of no use to earn superior returns. The semi-strong form implies that prices at any given time incorporate all publicly available information (including financial statements and news reports), i.e. when new information is released, it is fully incorporated into the price rather speedily. This is supported by the availability of intraday data-enabled tests which offer evidence of public information impacting stock prices within minutes (Patell and Wolfson, 1984, Gosnell, Keown and Pinkerton, 1996). And the strong form implies that prices at any given time incorporate all information, whether public or private (Frankfurter and McGoun, n.d.). Even insider information is of no use.

2.2.1 Implications of EMH

Fama persuasively made the argument that in an active market, that includes many well-informed and intelligent investors, securities will be appropriately priced and reflect all available information. The bottom line of the theory is that it is not possible to beat the
market since there is no way to know something about a stock that isnt already reflected in the stocks price and

it is not possible to predict stock prices or their future trends. Any attempt to

try and predict any patterns or pricing movements is rendered ineffective and useless.

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Chapter 2: Literature Review An efficient market also carries other implications for investment strategies mentioned below. In an efficient market:

A strategy of randomly diversifying across stocks or indexing to the market, carrying little or no information cost and minimal execution costs in order to optimise the returns, would be superior to any other strategy. This is also known as passive investment strategy. There would be no value added by portfolio managers and investment strategists. Equity research and valuation would be a costly task that would provide no benefits. The odds of finding an undervalued stock would always be random (50-50 chance). At best, the benefits from information collection and equity research would cover the costs of doing the research. (Damodaran 2002)

From the implications of EMH, it is not surprising to note that EMH evokes multitude criticism and strong reactions particularly on the part of portfolio managers and analysts, who view it as a challenge to their existence.

2.2.2 Supporters and Critics of EMH The debate about efficient markets has resulted in hundreds and thousands of empirical studies attempting to determine whether specific markets are in fact efficient and if so to what degree. It may be surprising to note that myriad researches have been found to confirm the EMH. Unarguably, no other theory in

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Chapter 2: Literature Review economics or finance generates more passionate discussion between its challengers and proponents. For example, in 1978, noted Harvard financial economist Michael Jensen famously pronounced that there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis, while investment expert Peter Lynch claims Efficient markets? Thats a bunch of junk, crazy stuff (Fortune, April 1995).

Malkiel (2005) argues that markets are indeed efficient and provides evidence that by and large market prices do seem to reflect all the available information. Underreaction to news events appears as frequently in the data as over-reaction to events, as has been stressed by Fama (1998). Many of the predictable patterns seem to disappear as soon as they are discovered, as emphasized by Schwert (2001) (in Constantinides et al, 2003). Event studies, pioneered by Fama et al (1969), found that stock prices respond quickly to new information, and subsequently display no apparent strong trends following major events such as mergers, stock-splits or changes in firms dividend policies. Their study also revealed that the market appears to anticipate the information, and most of the price adjustment is complete before the event is revealed to the market. Studies carried out by Working (1934) and Cowles and Jones (1937) which have been reported by Dimson and Mussavian (1998), confirmed that prices of US stock and other economic variables fluctuate randomly.

Malkiel (2003) and Eugene Fama (1970) summarize many early studies, conducted from the 1950s-70s, that show that after trading costs are considered, the returns

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Chapter 2: Literature Review generated by many technical strategies underperform a simple buy and hold strategy. Proponents of technical analysis counter that technical analysis does not completely contradict the efficient market hypothesis. Technicians agree with EMH in that they believe that all available information is reflected within a securitys price; that is why technicians say a study of the price movement is necessary (Anonymous I, 2006). Technicians argue that EMH ignores the realities of the market place, namely that many investors base their future expectations on past earnings, track records, etc. Because future stock prices can be strongly influenced by investor expectations, technicians claim it only follows that past prices can influence future prices. Technicians point to the new field of behavioural finance. The topic of behavioural finance is discussed later in detail. For present purpose, it suffices to note that behavioural finance essentially says that people are not the rational participants EMH makes them out to be. Market participants can and do act irrationally. Technicians have long held that irrational human behaviour influences stock prices and claim to have ways of predicting probable outcomes based on this behaviour (Anonymous I, 2006)3.

Kendall (1953) asserts that economists assume that time-series data on economic variables can be analyzed by making adjustment for long-term trends and examining the residual for short-term movements and random volatilities. He studied series of data on 22 UK stocks and commodity prices. He concluded that in series of prices which are observed at fairly close intervals the random changes from one term to the next are so large as to swamp any systematic effect which may be present. The data
3

See references for Anonymous I (2006) details.

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Chapter 2: Literature Review behave almost like wandering series. The correlation of price changes was close to zero (Dimson and Mussavian, 1998). These empirical observations were called the random walk model or even the random walk theory. According to this theory, current price is the best forecast for future price. Therefore, price changes from one period to the next are independent of past price changes. Future price can be predicted only once new information arrives and that information is unpredictable. Hence, one cannot predict the prices of stocks. Olsen, Dacorogna, Muller and Pictet (1992) state that the empirical studies confirm the efficiency of the major financial markets as well as the reflection of all information in current prices.

When EMH was first introduced, the theory gained a lot of momentum in the market and received support from many researchers through their empirical studies confirming that markets were indeed efficient. Undoubtedly, the studies based on EMH have made an invaluable contribution to the understanding of the securities market. However, there is lots of discontentment with the theory. Like all the theories, the Efficient Markets Hypothesis simplifies a complex reality, an argument also raised by Stout (2004), which is apparent from the premises it is based on like the presumptions of homogeneous investor expectations, effective arbitrage, and investor rationality.

A limited survey of the contemporary literature shows that criticism of EMH has gained both voice and momentum during recent years (Russel and Torbey, 2002). The initial euphoria about the EMH has faded and that conflicting opinions on market

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Chapter 2: Literature Review behaviour and efficiency have provided the impetus for the current debate that markets are not efficient.

The furious debate on whether markets are completely informationally efficient has spanned more than four decades, with some well-known critiques and anomalies4 exhaustively researched, rebutted, and researched yet again. For example, Grossman and Stiglitz (1980) argued that the EMH contained a theoretical contradiction. If all arbitrage profits were eliminated, and arbitrage is costly, then there would be no incentive for information search and acquisition; the very activity that made markets efficient would wither away.

Grossman (1976) and Grossman and Stiglitz (1980) go even farther. They argue that perfectly informationally efficient markets are impossibility, for if markets are perfectly efficient, there is no profit to gathering information, in which case there would be little reason to trade, and markets would eventually collapse. Alternatively, the degree of market inefficiency determines the effort investors are willing to expend to gather and trade on information. Hence, non-degenerate market equilibrium will arise only when there are sufficient profit opportunities, i.e., inefficiencies, to compensate investors for the costs of trading and information gathering. The profits earned by attentive investors may be viewed as economic rents that accrue to those willing to engage in such activities. Who are the providers of these rents? Black (1986) gave a provocative answer: noise traders, individuals who trade on what they consider to be information that is, in fact, merely noise. The supporters of the
4

An anomaly, in Thomas Kuhn's (1996) elegant phrase, is a violation of expectations

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Chapter 2: Literature Review EMH have responded to these challenges by arguing that while behavioural biases and corresponding inefficiencies do arise from time to time, there is a limit to their prevalence and impact because of opposing forces dedicated to exploiting such opportunities (Lo, 2004).

In recent years, many studies have demonstrated market inefficiencies by identifying systematic and permanent variations in stock returns. Some of these systematic variations, popularly known as anomalies, are small-firm effects, investment recommendations, and extraordinary returns to the time or the calendar effect5. The mere existence of investors like Warren Buffett and John Templeton prove that it is possible to select stocks and earn a higher return than an index fund.

Supporters of the Efficient Market Hypothesis gleefully point out that no investor in history has ever turned in a statistically significant out-performance of the market averages over a long period of time. Damodaran (2002) and Clarke, Jandik and Mandelker (n.d.), amongst many others, assert that the argument that EMH claims that investors cannot outperform the market is a myth and has been misinterpreted. And like them, many others sought to clarify this argument saying that - what the above argument exactly means is, EMH does not imply that investors are unable to outperform the market. What EMH does claim, though, is that one should not be expected to outperform the market predictably or consistently. However empirical evidences have proved that there are investors in the market who have been consistently beating the market. One such well-known and known-to-be worlds
5

Appendix 1 provides a description of all the popular anomalies.

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Chapter 2: Literature Review greatest investor (mentioned earlier) is Mr. Warren Buffet, an American investor and the second richest man in the world6, who made his fortune mainly through investments in the stock market. Between 1957 and 1969, Warren Buffet beat the Dow Jones Industrial Average by 22 percentage points (Hangstrom, 1997, p. 4). Bill Miller (of Legg Mason) is another such example who has beaten the stock market for 14 consecutive years (Heimer, 2005).

If the EMH were literally true, after all, Warren Buffett would not exist. The wizard of Omaha and a handful of other high-visibility investors, mostly disciples of the late Benjamin Graham, have outperformed the market averages with EMH-defying regularity (Hecter, 1988). In recent years scholars have documented a host of other anomalies - persistent moneymaking opportunities that an unfailingly efficient market should long ago have arbitraged into oblivion. They have found that small-company stocks consistently yield higher returns than large ones, even after adjusting for risk. Year after year, share prices rise in early January. More often than not, they fall on Mondays (Hecter, 1988).

There have been several studies that suggest that value stocks have higher returns than so-called growth stocks. The most common two methods of identifying value stocks have been price-earnings ratios and price-to-book-value ratios. Stocks with low price-earnings multiples (often called value stocks) appear to provide higher rates of return than stocks with high price-to-earnings ratios, as first shown by Nicholson (1960) and later confirmed by Ball (1978) and Basu (1983). This finding is
6

Forbes World Richest People 2006 list

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Chapter 2: Literature Review consistent with the views of behavioralists that investors tend to be overconfident of their ability to project high earnings growth and thus overpay for growth stocks (for example, Kahneman and Riepe, 1998). The finding is also consistent with the views of Graham and Dodd (1934), first expounded in their classic book on security analysis and later championed by the legendary U.S. investor Warren Buffett (Malkiel, 2003).

Proponents of EMH claim that market efficiency implies that given the number of investors in financial markets, the law of probability would suggest that a fairly large number are going to beat the market consistently, not because of their investment strategies but because they are lucky (Damodaran, 2002. p. 114). However, there exist a number of investors who have outperformed the market over long periods of time, in a way which it is statistically unreasonable to attribute to good luck, including Peter Lynch (formerly of Fidelitys Magellan Fund), Warren Buffett, John Templeton (of Templeton funds), John Neff (of Vanguards Windsor Fund) and Bill Miller (of Legg Mason) (Paquette et al, n.d.). These investors strategies are to a large extent based on identifying markets where prices do not accurately reflect the available information, in direct contradiction to the EMH, which explicitly implies that no such opportunities exist (Anonymous, 2006). This demonstrates that in addition to luck, skill is a significant input, and it should be no surprise if one individual systematically beats all others.

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Chapter 2: Literature Review Theorists often describe an efficient securities market as one in which prices fully reflect all available relevant information. Yet as Gilson and Kraakman (1984) pointed out, information is costly to obtain, process, and verify. As a result it is impossible for every participant in securities markets to actually acquire, understand, and validate all the available information that might be relevant to valuing securities (Stout, 2004). Efficient market, as we discussed earlier, implies that the prices fully reflect available information. In this regard, many critics have raised a doubt and argued that informational efficiency, alone, does not imply that market prices respond to new information correctly or even that prices respond at all (Stout, 2004). Another attack on the proponents of the theory is on their assertion that security prices reflect all public information. In the years immediately following the development of the EMH it was subjected to extensive empirical testing as researchers analyzed how quickly prices responded to public announcements of stock splits, corporate mergers, and the like. These first studies found that prices seemed to respond to new information almost immediately, within hours or minutes of an announcement. But consider the kind of information researchers initially used to test market efficiency. Merger announcements and stock split reports are widely disseminated and easy to understand (Stout, 2004). What happens when new information becomes available but investors must invest substantial time, trouble, or money to get it? What happens when the information is technical and difficult to understand? Do prices still change within hours or minutes? As Brealey & Myers note (2000, p. 363-65), more recent studies suggest the answers to these questions is no. Many types of information important to valuing securities seem to be

22

Chapter 2: Literature Review incorporated into prices far more slowly and incompletely than the conventional account of market efficiency suggests. A good example is the widely-studied phenomenon of post-earnings-announcement-drift. An unanticipated announcement of increased corporate earnings tends to be followed by abnormal positive returns over the next several months, while firms that announce unexpectedly poor earnings see abnormal negative returns over an extended period (this is known as postearnings-announcement drift). Researchers have been puzzled over these results. Bernard & Thomas (1989) suggest drift is evidence that the initial price response to the new earnings information is incomplete, and that the full implications of the new earnings information are digested by the market far more slowly than previously suspected. Information that is easy to understand and that is popularized and iterated in the media may be incorporated into prices almost instantaneously. Information that is public but difficult to obtain, or information that is complex or requires a specialists knowledge to comprehend, may take weeks or months to be reflected in price. Indeed, it may never be fully reflected at all (Stout, 2004). Therefore, the possibility of informationally inefficient markets undermines the most vital proposition of the EMH that you cant beat the market by trading on public information.

Many economists, mathematicians and market practitioners find it difficult to believe that man-made markets are strong-form efficient when there are prima facie reasons for inefficiency including the slow diffusion of information, the relatively great power of some market participants (e.g. financial institutions), and the existence of

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Chapter 2: Literature Review apparently sophisticated professional investors (Anonymous, 2006). The way that markets react to news surprises is perhaps the most evident flaw in the EMH. HBR (1964) in its editorial article entitled, Urgent questions about the stock market, indicate that valuation, information, manipulation, fashion and dissatisfaction are the obstacles in better pricing of equity shares.

Furthermore, as Russel and Torbey (2002) argue that although it is true that the market responds to new information, it is also clear through many empirical evidences that information is not the only variable affecting security valuation. Recent years have witnessed a new wave of researchers who have provided thought provoking, theoretical arguments and supporting empirical evidence to show that security prices could deviate from their equilibrium values due to psychological factors, fads, and noise trading, discussed in the next section.

Another problem with EMH is that it assumes that all investors perceive all available information in precisely the same manner. The numerous methods for analysing and valuing stocks pose some problems for the validity of the EMH. If one investor looks for undervalued market opportunities while another investor evaluates a stock on the basis of its growth potential, these two investors will already have arrived at a different assessment of the stocks fair market value. Therefore, one argument against the EMH points out that, since the balance of investors value stocks differently, it is impossible to ascertain what a stock should be worth under an efficient market (Bergen, 2004).

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Chapter 2: Literature Review A considerable body of academic work on asset pricing has stressed that stock markets are somewhat predictable, and in some circumstances inefficient. Fama and French (1988) in their paper on permanent and temporary components of stock prices found returns to possess large predictable components casting doubts about the efficiency of the stock market. Blanchard and Watson (1982) show that when the bubble is present, the proportional change in stock prices is an increasing function of time and therefore predictable; further, as time increases, the bubble starts dominating fundamentals, which can be tested by regressing the proportional change in stock prices on time. Lo and Mackinlay demonstrate that there is momentum in the stock market and that the random walk hypothesis can be rejected (Malkiel, 2003, I, p.9).

Summers (1986) opined that financial markets were not efficient in the sense of rationally reflecting fundamentals. Several theorists, economists and researchers have pointed out that the market cannot be perfectly efficient, or there would be no incentive for professionals to uncover the information that gets so quickly reflected in market prices, a point stressed by Grossman and Stiglitz (1980). In their survey of the econometrics of financial markets, Campbell et al (1997), for example conclude that stock markets are atleast partially predictable. DeBondt and Thaler (1995) survey the body of work on behavioural finance and suggest that stock prices often deviate substantially from their fundamental values. In their view, such deviations can be used by investors to fashion winning investment strategies. Shiller (2000) documents the behavioural factors that lead to investment bubbles and also argues that future

25

Chapter 2: Literature Review stock prices are to some extent predictable. Appendix 2 lists the predictions made by EMH and the empirical evidence on the former.

2.2.3 Behavioural Finance and EMH

Market efficiency has been challenged by behavioural finance, described in a recent New York Times article as the brand of economics that tries to explain the market in terms of the way humans behave - both rationally and not (Nocera, 2005). Lintner (1998) defines behavioural finance as being the study of how humans interpret and act on information to make informed investment decisions (p.7).

Many investors have long considered that psychology plays a key role in determining the behaviour of markets. In the 1990s, emergence of behavioural finance with its discovery of systematic biases in human judgment leading to doubts that human beings can be counted on to take a strictly rational approach to decision making (Kahneman, Slovic, Tversky, 1982) strongly breached the concept of efficient market and threw light on many aspects of human behaviour which showed that markets rather behave inefficiently.

Frankfurter and McGoun (n.d.) illustrate Dremans (1979) argument for behavioural finance. Dreman (1979) builds his argument on psychological factors, proposing that investors react to events in a fashion that consistently overvalues the prospects of the best investments and undervalues those they consider the worst. Dreman and Berry (1995) summarize the following predictions of the overreaction hypothesis:

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Chapter 2: Literature Review 1. For long periods best stocks underperform while worst stocks outperform the market. 2. Positive surprises boost worst stock prices significantly more than they do for best stocks and negative surprises depress best stock prices much more than they do for worst stocks. 3. There are two distinct categories of surprises: event triggers (positive surprises on worst stocks, and negative surprises on best stocks), and reinforcing events (negative surprises on worst stocks and positive surprises on best). Event-triggers result in much larger price movements than do reinforcing events.

Several event studies have shown evidence of under-reaction in which the market response to new information appears to be too little or too late. Bernard and Thomas (1990) and Abarbanell and Bernard (1992) show that financial analysts under react to earnings announcements, either overestimating or underestimating quarterly earnings after positive or negative surprises. Michaely, Thaler and Womack (1995), find price responses to dividend cuts and/or initiations to continue for an excessively and irrationally long time. Ikenberry, Lakonishok and Vermaelen (1995) contend that investors under-react to firms share repurchases. Investors do not, in fact, discount information in the rational manner suggested by theory. As a result, it is possible for the stock market to remain for long periods at levels far removed from intrinsic value (Frankfurter and McGoun, n.d.).

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Chapter 2: Literature Review Other human frailties, like the tendency to place too much weight on the most recent data, may cause investors, and thus market prices, to overreact to news. Predictable overreaction allows for a market timing strategy of buying on bad news, or buying stocks whose prices have recently dropped. On the other hand, another assertion is that all but a few investors neglect certain obscure stocks. This belief motivates basic fundamental analysis, as well as technically based momentum strategies; buying stocks whose prices have started to rise. The point is that if some investors are irrational, and the irrationality is pervasive enough, some stocks will be mispriced and the market will be inefficient (Thorley, 1999).

In fact, behavioralists, in consensus, argue that for anyone whos been through the Internet bubble and the subsequent crash, the EMH is hard to swallow. They explain that, rather than being anomalies, irrational behaviour is commonplace. In fact, researchers have regularly reproduced market behaviour using very simple experiments. Two other common behaviour outlined by behavioralists are:

The Herd versus the Self: Herd instinct explains why people tend to imitate others. When a market is moving up or down, investors are subject to a fear that others know more or have more information. As a consequence, investors feel a strong impulse to do what others are doing. Here, for example, is a good description of herding - people suspending their private judgments and acting on public information.

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Chapter 2: Literature Review Two restaurants face one another on the main street of a charming Alsatian village. There is no menu outside. It is 6:00 PM. Both restaurants are empty. A tourist comes down the street, looks at each of the restaurants, and goes into one of them. After a while, another tourist shows up, sees how many patrons are already inside by looking through the stained glass windows these are Alsatian winstube - and chooses one of them. The scene repeats itself, with new tourists checking on the popularity of each restaurant before entering one of them. After a while, all newcomers choose the same restaurant: they choose the more popular one irrespective of their own information. - Chamley (2004) Lamont (2004) seeks to explain herding in a simple model in which uninformed traders (dumb money) overwhelm informed traders (smart money) in speculative bubbles. Hoguet (2005) explains as markets rise, investment managers who underweight a market buy into it, irrespective of valuation, to reduce their risk of underperforming the benchmark.

Investors tend to place too much worth on judgments derived from small samples of data or from single sources. For instance, investors are known to attribute skill rather than luck to an analyst that picks a winning stock (McClure, 2002).

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Chapter 2: Literature Review In fact, the so-called herding behaviour of stock market players has been commonly found to take place in financial markets. Hoguet (2005) asserts that herding is particularly common in emerging markets. He alleges that the performance of Japanese stocks in the 1980s and NASDAQ in the 1990s are two prominent examples of overshoots. In emerging markets, Taiwanese shares fell 75% in six months in 1990.

Human patterns of less-than-perfectly rational behaviour are central to financial market behaviour, even among investment professionals. Julius Caesar said Men willingly believe what they wish7. His insight was on target. This statement has been well elaborated as an explanation for the stock market crashes and bubbles by the behavioralists. It has been shown in a number of psychological studies that people suffer a wishful thinking bias, that is, they overestimate the probability of success of entities that they feel associated with. Wishful thinking bias appears to play a role in the propagation of a speculative bubble. After a bubble has continued for a while, there are many people who have committed themselves to the investments, emotionally as well as financially (Shiller, 2001), which further causes the prices to deviate unjustifiably from their intrinsic value and causing this process to continue for a longer time. By the time it is realized that the prices are irrational, the market has crashed and people have lost significant amount of wealth.

Julius Caesar, De Bello Gallico, pp. iii, 18.

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Chapter 2: Literature Review Behavioural finance certainly reflects some of the attitudes embedded in the investment system. Behaviourists will argue that investors often behave irrationally, producing inefficient markets and mispriced securities - opportunities to make money. That may be true for an instant. But, consistently uncovering these inefficiencies is a challenge. Questions remain over whether these behavioural finance theories can be used to manage money effectively and economically. The irrationalities present amongst the Indian stock markets participants have been explored in the findings and analysis sections.

2.2.4 EMH and Investors strategy of Investment or Speculation

The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists. - Graham (2003)

The EMH and John Maynard Keynes (1936) philosophy represent two extreme views of the stock market. EMH is built on the assumption of investor rationality, which is in stark contrast to Keynes philosophy in which he pictures the stock market as a casino guided by animal spirit. He argues that investors are guided by shortrun speculative motives. They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short-run price movements (Russel and Torbey, 2002).

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Chapter 2: Literature Review There is a line to be drawn between investment and speculation. Graham (2003), in his bestseller that made the foundation of many great investors investment strategy of value investing including Warren Buffett, clearly made a distinction between an investor and a speculator. In his definition, an investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative (p. 29). The thorough analysis that he insisted upon was explained as the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and sound logic.

Graham says, investors judge the market price by established standards of value, while speculators base [their] standards of value upon the market price.

In 1999, at least 6 million people were trading online and roughly a tenth of them were day trading, using the Internet to buy and sell stocks at a lighting speed. It somehow became an instant way to mint money. By pouring continuous data about stocks into bars and barbershops, kitchens and cafes, taxicabs and truck stops, financial websites and financial TV have turned the stock market into a non-stop videogame. The public felt more knowledgeable about stock markets than ever before. Unfortunately, while people were drowning in data, knowledge was nowhere to be found. Stocks had entirely decoupled from the companies that issued them pure abstractions, just blips moving across a TV or a computer screen (Zweig, J. in Graham, 2003, P. 39).

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Chapter 2: Literature Review For the capital market comprising for speculators, the theory of EMH would hold to a great extent, in the sense that they cannot exactly predict the prices. It would be more a matter of luck rather than skill out of which they can make the money in the market. Their interest is in the short-term price movements in the market, with majority of them conducting their trading on a days basis, also known as day-trading or jobbing. Buffett also supports this argument and says that he gives zero credence to market predictions. He cannot predict the short-term market movements and does not believe that anyone else can. He has long felt that the only value of stock forecasters is to make fortune tellers look good (Hangstrom, 1997, p. 51). Traders make the short-term market efficient because they trade on rumours and news and are very close to the source of this information. They move the market rapidly upward or downward when something is announced. However traders seem to be quite inept at pricing stocks properly. They move stocks up or down, but they dont settle on any correct judgment of intrinsic value. Most traders dont care about intrinsic value anyway, seeing truth in prices.

Speculators comprise a big chunk in the stock market. They are the people who trade in the market on the basis of the tips or the hot tips that is readily available everywhere. This causes the prices of the stocks to deviate from their fundamental values and sometimes this deviation is so broad that it may cause a crash in the market, examples of such behaviour are the so-called Bubbles.

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Chapter 2: Literature Review

2.3 The Behaviour of Institutional Investors

Proponents of EMH have long been challenging the performance of institutional investors and have been arguing that if markets are not efficient and there are opportunities of profiting above the market returns, anomalies exist, and with all the resources and skills they have, why are the analysts, active managers and other money managers not able to beat the market. Nearly all mutual and pension funds also fail to beat the market on a consistent basis. Damodaran (2002) also argues that there seems to be little evidence of money managers being able to exploit the socalled profiting opportunities to beat the market.

The recent empirical literature also suggests that institutional or professional investors have been able to do a little better than the market, and that there is persistence of performance among investors. One reason that institutional investors may not do better is that they feel that they are dealing with clients who have expectations of them that make it difficult to pursue their own best judgment. The clients expect them to invest in accordance with certain fads. The clients expect them to trade frequently, or, at least, are not willing to pay high management fees unless they do so. These effects dilute the advantages that institutional investors naturally have. Another reason that the differences are so small is that institutional investors do not feel that they have the authority to make trades in accordance with their own best judgments, which are often intuitive, that they must have reasons for what they do, reasons that could be justified to a committee. Their obeisance to conventional wisdom hampers their investment ability (Shiller, 2001).

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Chapter 2: Literature Review Another explanation for the institutional investors not able to beat the market or atleast not so after considering their research and other expenses, as offered by Damodaran (2002) and also supported by other researchers, maintains that portfolio managers do not consistently follow any one strategy for investment. But they rather jump from one strategy to another, both increasing their expenses and reducing the likelihood that the strategy can generate excess returns in the long-term.

2.4 EMH in Indian context

2.4.1 Introduction
Despite being a developing economy, India has a mature stock market, established well over a hundred years ago. The first stock exchange in India, established at Bombay in 1885, has more than 6200 listed companies (Emerging Stock Markets, 1990, published by IFC). This number is exceeded only by the NYSE and is much larger than number of listed companies in other stock markets in the world (Barua and Varma, 2006). However, the Indian stock markets are characterized as the emerging markets.

India liberalized its financial markets and allowed Foreign Institutional Investors to participate in their domestic markets in 1992. Ostensibly, this opening up resulted in a number of positive effects. First, the stock exchanges were forced to improve the quality of their trading and settlement procedures in accordance with the best

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Chapter 2: Literature Review practices of the world. Second, the information environment in India improved with the advent of major foreign institutional investors (FIIs) in India. Emerging Markets are typically characterized by low liquidity, thin trading, possibly less-informed investors with access to unreliable information and considerable volatility. In addition, emerging markets by their very nature change rapidly through time. The dismantling of barriers to the flow of capital both within the country and from external sources will cause changes in the intuitional and regulatory environments. In turn, this will impact on both the informational and allocational efficiency of the markets, rather than simply taking a snapshot of the market at a particular point in time (Tamakloe, 2003).

Although India is an emerging market, the less-informed investor characteristic does not imply much in Indian case. Investors have availability to all public information, but whether they use all available information for investment purposes is not known.

2.4.2 Studies on Indian Capital Markets in context of EMH

For emerging Indian stock markets, there have been a number of studies on the question of efficiency. The results from the studies are mixed. Vaidyanathan and Gali (1994) in their test for the existence of weak form of efficiency of the Indian capital market have provided supportive evidence for the weak form of efficiency in the Stock Exchange, Mumbai (BSE). Mallikarjunappa (2004) examined the efficiency of the Indian stock market in the semi-strong form using event study. His study was based on sensitive index (Sensex) based companies of BSE. Returns were computed

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Chapter 2: Literature Review using the price data of companies and the Sensex. The results of his studied showed that the Indian market is not efficient in the semi-strong form. Studies by Barua (1981), Sharma (1983), Gupta (1985) also indicate weak form of market efficiency. Ray (1976), Sharma and Kennedy (1977), Barua (1981), Ramachandran (1984), to name a few, have found the Indian stock market to be efficient in the weak and the semi-strong form. This conclusion arrived at using the conventional method of testing market efficiency is in line with similar works in markets in the developed economies. Poshakwale (2002) examined the random walk hypothesis in the Indian stock market (i.e. BSE). The broad conclusion of his study and tests show that the Indian market does not conform to a random walk and hence rejects the Random Walk Hypothesis. He also asserts that his results are largely consistent with the previous research in the US and UK.

Sehgaland and Tripathi (2005) have found the evidence of the size based investment strategy providing statistically significant extra normal returns in Indian stock market. Their research finds out that a strong size effect exists in the Indian stock market during the period 1990-2003. They say that such evidence casts serious doubts about the level of market efficiency (semi-strong form). Patel (2000) also reported the presence of strong size effect in 9 out of 22 emerging markets including India over the period 1988-1998. Mohanty (2001) documented the presence of strong size effect in Indian stock market over the period 1991-2000 using the market capitalization as the measure of firms size.

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Chapter 2: Literature Review Behaviour of institutional investors in India can provide an explanation of the cause of some inefficiency in the Indian stock market. Pitabus (2001) through his research on Efficiency of the Market for Small Stocks found out that in India institutional investors prefer to invest their money in the liquid stocks. In the case of a liquid stock, one can easily buy or sell a large number of stocks without affecting the price much. By investing only in liquid stocks, the large investors are able to reduce certain transaction costs, like the impact costs. In the study conducted by Pitabus, it was found that there is a very high correlation between liquidity of the stock and the size of the company. Hence, the large investors usually invest only in the large stocks. Mr. U R Bhat, the Chief Investment Officer of Jardine Fleming, once remarked that in India, for the foreign institutional investors Big is Beautiful (Mohanty, 2000). Since the institutional investors do not pay much attention to small-stocks, there is not much availability of equity research in such stocks. Hence, if an investor wants to buy stocks of small companies he has to generate the equity research himself, which entails costs, which the investor might not be willing to pay. Thus these stocks do not generate much interest in the market and remain undervalued causing inefficiency and profit opportunities.

Barmans (1999) study finds that fundamentals rather than bubbles are more important in the determination of stock prices in the long run in the Indian market; however, discerns contribution of bubbles, mild though it is, in stock prices in the short run. Batra (2003) provides evidence of the herding behaviour in the Indian markets. Using both daily and monthly data, she finds that FIIs tend to herd in the

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Chapter 2: Literature Review Indian market and the herding measure being high for the monthly horizon. Gokaran (2000) has studied the financing patterns of the corporate for growth in India. The study indicated that equity markets suffer serious inadequacies as a mechanism for raising capital. There is more speculation by investors rather than investment orientation.

Obaidullah (1991) used sensex data from 1979-1991 and found that stock price adjustment to release of relevant information (fundamentals) is not in the right direction, implying presence of undervalued and overvalued stocks in the market. Barman and Madhusoodan (1993) in their RBI Papers found that stock returns do not exhibit efficiency in the shorter or medium term, though appear to be efficient over a longer run period.

Like other markets, even in Indian market no consensus has been reached about whether the markets are efficient or not, as can be seen from the studies above. In context of behavioural finance, not much research has been conducted on Indian capital markets.

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Chapter 2: Literature Review

2.5 Markets are Efficient or Inefficient? Truce between the two?

I think that our gurus proved the point without a doubt. The efficient market theory is flawed. There are simply too many examples of stocks that were discovered by a great manager before anyone else knew what was going on. Peter Tanous (1997)

Most of us probably would do better to buy an index fund or throw darts at the Wall Street Journal. But we also should think twice before assuming markets are even informationally efficient. (2004) - Stout

Market efficiency is always a goal in the marketplace. We all want to get the value we pay for. However, as mentioned earlier, the market will always overvalue and undervalue common stocks due to the human emotions that drive it. By assuming efficient markets, academics can conduct empirical investigations and come to robust conclusions. As a result, the EMH has literally spawned much recent research and has become entrenched as a truth in the minds of many academics. But, unfortunately, the golden goose may not to be so golden (Downe et al, 2004). Even Burton Malkiel, one of the most lucid proponents of market efficiency, agrees that after the fact, we know that markets have made egregious mistakes (Malkiel 2003, p. 61).

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Chapter 2: Literature Review Bergen (2004) argues that although it is relatively easy to pour cold water on the EMH, its relevance may actually be growing. With the rise of computerized systems to analyse stock investments, trades and corporations, investments are becoming increasingly automated on the basis of strict mathematical or fundamental analytical methods. Given the right power and speed, some computers can immediately process any and all available information, and even translate such analysis into an immediate trade execution. However, despite the increasing use of computers, most decisionmaking is still done by human beings and is therefore subject to human error. Even at an institutional level, the use of analytical machines is anything but universal. While the success of stock market investing is based mostly on the skill of individual or institutional investors, people will continually search for the sure-fire method of achieving greater returns than the market averages.

Also, the theory of EMH is not science and researchers have argued that it is not possible to test the efficiency of a capital market with complete accuracy. Much of EMH is untestable, unverifiable and non-science and thus cannot be confirmed or negated through rigorous assessment. This has resulted in protract disputes between those who supported the EMH and those who did not (McMinn, 2004). According to Roll (1997), EMH (is) one of the most controversial and well-studied propositions in all the social sciences. It is disarmingly simple to state, has far-reaching consequences for academic pursuits and business practice and yet is surprisingly resilient to empirical proof or refutation. Even after three decades of research and literally thousands of journal articles, economists have not yet reached a consensus

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Chapter 2: Literature Review about whether markets - particularly financial markets - are efficient or not (Roll, 1997).

The fury of the market efficiency battle is so great that one can easily miss Famas (1991) statement that market efficiency per se is not testable (p. 1575) (in Statman, 1999).

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Chapter 3: Methodology

CHAPTER 3: METHODOLOGY
3.1 Introduction Methodology is a framework within which a research is conducted (Remenyi et al,
1995). Methodology and a good structure formulation can ensure a good logical flow of information and helps reduce complexity within a research.

The aim of this chapter is to illustrate the research approach adopted, including how data were collected, the rationale of those data collection methods and a discussion of the validity and reliability of these research methods. It also outlines how the whole research was carried out.

3.2 Qualitative Research and Quantitative Research

Research is a systematic investigation to find answers to a problem. The two main broad categories that any research comprises of are Qualitative Method and Quantitative Method. Considering the broad based nature of the research and the need to conduct in-depth analysis, the qualitative research technique seemed to be the most suitable for this research work. More formally, as Fraenkel (1993) puts, no matter how statistically powerful a nomothetic (quantitative research) finding is, it can never definitively predict experience and action of the individual person (qualitative research) (quoted in Nau, 1995).

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Chapter 3: Methodology The research methods used in this study are mainly qualitative. There are two main reasons for this. Firstly, research conducted showed that although there has been a lot of statistical research produced on the validity of EMH in Indian capital markets no study attempted to find out what market participants believe about the theory. And in order to find out this, qualitative research was the only method that could be used effectively.

The aim of the dissertation is to explain the efficiency of Indian stock market and how can investors beat the market, i.e. if it is possible to beat the market. After evaluating the topic and aim of research, qualitative research method is most appropriate for following reasons:

There have been quantitative research and statistical tests conducted on the Indian stock market to find out if the markets are efficient or not. However, no study has yet tried to look on the topic area from the qualitative perspective, which in my opinion is an equally vital area of study. The reason being that the statistical or the quantitative perspective always looks at the sample and concludes its results on the basis of what the majority holds. However, in this research, the aim has been to find out if it is possible to beat the market. The history and logic suggests that if everyone would have been able to outperform the market consistently and it would have been an easy job, everyone in this world would have been rich and all the problems would have been solved. But this is not the case. Albeit the quantitative studies suggest

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Chapter 3: Methodology that markets are efficient, there are people who have proven the theory wrong by the exceptional returns on their investment. Thus, it is important to study this subject from a different stance, particularly in the Indian capital markets, which this research is endeavouring to accomplish. In order to understand the behavioural factors that affect the capital market participants and market as a whole, qualitative research methodology is the most relevant method for data gathering and analysis. The quantitative study and statistical methods will not be helpful in identifying these factors. Through this research the researcher aspires to improve her understanding and broaden her knowledge of the capital markets and the participants behaviour in context of Indian capital markets. With the help of this research, the researcher also aims to improve the Research Department of the company, Arihant Capital Markets Limited, which she intends to work with. Thus, qualitative research would help to meet the objectives as through this research rather than being an outside-researcher looking in, the researcher is more likely to be involved with the people, organization - engaging perhaps in participant observation, which is not possible in a quantitative study.

3.3 Research Map

Figure 1 outlines how the whole research was done and illustrates all the stages of the research from the beginning, to the conclusion.

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Chapter 3: Methodology FIGURE 1

(Source: Author8)

The key research question was selected, then the research process started and information gathering was done, which began with secondary research and then at a later stage primary research was conducted. The collected data was then evaluated and finally the research was concluded on the basis of the research and analysis part.

Author indicates the person who carried out this research

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Chapter 3: Methodology

3.4 Research Methods

The method tools chosen for the research were appropriate as they helped in obtaining valuable information and knowledge.

3.4.1 Secondary Research

Secondary data is data that has been collected for some other purpose and can be used to answer research questions (Saunders et al, 2003). In answering the research questions and meeting the objectives of this dissertation, secondary data has a restricted application.

The secondary research conducted mainly falls into the heading of the literature review. However, some articles on Indian capital markets and also the Indian analysts view have been used in the data gathering and analysis stage.

In order to acquire profound knowledge and information of relevant areas of research, secondary research has assisted in getting information on specific subject problems, developed theories and research questions. The secondary research also aided in the creation of questions for interviews.

3.4.2 Primary Research

Primary research is data that is actually collected from the natural world (including experiments, interviews, case studies, etc.) and is collected specifically for the study at hand. For data collection, this study has used the qualitative research technique of

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Chapter 3: Methodology direct communication with the research participants through interviews, discussed in detail in next section.

Primary research was pivotal to this research and was the main source of data gathering. Primary research tools were used because they provide the opportunity to interact with people and obtain desired information. Interviews were conducted to get the answers to the research questions and acquire profound information from the experts and professionals in the investment arena in Indian stock markets.

3.5 Methodology and Data

3.5.1 Methodology Framework
This section outlines the Methodology Framework, i.e. the use of particular strategies and tools for data gathering and analysis and the rationale for the choice of methodology for data gathering and for data analysis through a diagram.

Figure 2 basically provides a broad framework of the methodology (taken from Saunders et al, 2003), that is discussed in the next section.

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Chapter 3: Methodology FIGURE 2

(Source: Author)

3.5.2 Research Setting, Procedures, Participants and Materials

As suggested by Sanger (1996), for qualitative research methods, interviews are the predominant means of data collection. As defined by Khan and Cannell (1957, pp. 149), interview is a conversation with purpose.

In order to get the most valuable information and well-focused comments and advices on the specific research topics from the experts and professionals, the research method employed in accessing primary data was semi-structured face-to-face interviews and telephonic interviews with capital market analysts, mutual fund managers, individual and other institutional investors (I Is).

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Chapter 3: Methodology An interview is advantageous (Easterby-Smith et al., 2002; Healey, 1991):

Where there are many questions to be answered When the questions may be open ended Where the order of questioning may need to be varied

All the above mentioned points justify the selection of interviews for data gathering in this research project.

The semi-structured interview is one of the most frequently used qualitative methods. They provide an opportunity to probe answers and the interviewees can be asked to explain, or build on their responses (Saunders et al, 2003). For example, in order to understand the psychology of investors and identify the irrationalities on part of the investors, it was required that the respondents be probed to get answers different from the past researches and specifically in context of Indian markets, which might not have been possible without a semi-structured interview. In fact, when the interviewees were asked to outline some irrational behaviour of investors most of them initially quoted herding behaviour as the answer and provided examples on that. But only when asked to think of some other such behaviour did they actually reflect over the question and provided further examples of such behaviour.

Britten (1995) explains that semi-structured interviews are conducted on the basis of a loose structure consisting of open ended questions that define the area to be explored, at least initially, and from which the interviewer or interviewee may diverge in order

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Chapter 3: Methodology to pursue an idea in more detail. Many questions evolved during the course of the interview and hence the choice of semi-structured open-ended interview proved quite beneficial.

Nevertheless, as the aim is to capture as much as possible the subjects thinking about a particular topic, interviewer can raise new questions during the interview. Consequently, at the end, every interview can be different from the other. In fact, during the interview stage, some new points were discovered, which were later asked to the other respondents to elaborate and express their view on. The respondents were informed before the interview that the question sheet is just an outline of the topics to be covered. For example, in the second interview, the respondent mentioned that discipline is very important when making investment decisions and most of the investors lose money because they are not disciplined which was a new and interesting point. In subsequent interviews, the author later investigated on the discipline aspect of investment and found some very interesting results and answers, discussed in the findings and analysis section on page 96.

Thus, semi-structured interviews were used for collecting data as it was the best option to get the answers to the research questions and meet the objectives of this research. And they certainly proved to be a very useful strategy for collecting data.

The interviews were based on a series of open questions, which were used as a pointer for a wide-ranging discussion on

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Chapter 3: Methodology the efficiency level of Indian stock market, what irrationalities are investors prone to that affect their performance, whether I Is are able to beat the market consistently, the behaviour of various market participants, what investment strategy should be adopted by investors, and how can investors identify good investment opportunities9.

3.5.2.1 Sampling
For some research questions it is possible to survey an entire population if it is of a manageable size. Sampling (Saunders et al., 2003) is a valid alternative when:

It would be impracticable for you to survey the entire population Your budget constrains prevent you from surveying the entire population; Your time constrains prevent you from surveying the entire population;

In this dissertation, sampling is valid for most of the above mentioned reasons. There were time constraints as well as budget constraints for the researcher. Sampling also saves time, which was an important consideration for this dissertation. The purposive sampling technique has been used due to the fact that this sampling technique allows the researcher to use their personal judgment to select cases that best enables the researcher to answer the research questions and meet the objectives (Neuman, 2000).

Refer to Appendix 5 for interview questionnaire.

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3.5.2.2 Research setting

The interviews were held in eight different sessions individually with each interviewee, 5 of them in Mumbai on 09th and 10th November 2006 at the offices of respective interviewees, 2 interviews in Indore on 11th November 2006 and 1 telephonic interview with an interviewee in Bangalore (all in India). The seven interviews were conducted at the respective offices of the interviewees because they preferred the location for their convenience. Telephonic interview was conducted because the interviewee preferred a telephonic conversation to a face-toface interview. Moreover, it was also not possible for the researcher to go to Bangalore for just one interview.

3.5.2.3 Research Participants and Procedures

Eight interviews were conducted from different analysts and investors, ranging from institutional to individual investors in Indian stock markets. Collecting data from fewer subjects means that the information can be more detailed (Saunders et al., 2003). The Interviewees were selected on the basis of following criteria:

- Experience in Indian stock markets and their knowledge of the research subject. - Their association with the stock market. - What sort of portfolio they manage active or passive; the size of the fund they manage (in case of institutional investors). - What companies are they associated with. - Diversity of background and job situations.

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Chapter 3: Methodology All the participants had excellent experience of Indian capital markets and were well acquainted with the concept of market efficiency, passive and active investment strategies and behavioural finance, which made the interview-process an enriching experience. In order to get insight on the subject from different perspectives, it was made sure that the participants/sample selected was diversified. Therefore, the sample included participants from mutual fund companies, stock broking companies and other institutional and individual investors. Participants included fund managers managing funds between Rs. 600 crores- Rs. 10,000 crores10 of both domestic and foreign investors. The sample also included both the proponents of active investment strategy and passive investment strategy.

Table 3 summarises the names and profiles of the interviewees11:

TABLE 3 Interviewee
Institutional Investors Hudson Fairfax Group (HFG) is a US based investment firm focused on sponsoring and promoting India-related investments. Mr. Ravi has 14 years of experience in the Indian capital markets and has a broad and successful background in Indian equities, including value and growth investing in both large and mid capitalization stocks. Benchmark is the only asset management company in India that purely invests through indexing. Mr. Jain has 8 years experience in Indian capital markets.

Position

Profile

Mr. Ravi Gopalakrishnan

Portfolio Advisor to Hudson Fairfax Group (HFG)

Mr. Vishal Jain

Vice President, Investments and Fund Manager to Benchmark Asset Management Company

10 11

Approximately 71million-1billion Refer Appendix 3 for detailed profiles of the interviewees

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Chapter 3: Methodology
Managing Director of Atlantis Investment Advisors India Ltd Mr. Singh is also the Portfolio Adviser to the Atlantis India Opportunities Fund. Atlantis is a leading asset manager, specializing in Asian equities. Mr Singh holds a distinguished reputation in the industry and has more than 15 years experience of Indian capital markets. Mr. Singhal is also associated with the Indian capital markets and is involved in the investment arena.12 Mr. Sambre is a Chartered Accountant and offers investment advice to the private client group.

Mr. B. P. Singh

Mr. Rajesh Singhal

Anonymous Product Analyst and Assistant Vice President of Global Private Client division of DSP Merrill Lynch.

Mr. Vinit Sambre

Mr. Ashok Lunawat

Research Head of Arihant Capital Markets Ltd.

Mr. Lunawat is the Research Head of Arihant Capital Markets Ltd, which is a leading stock broking firm in India. A Chartered Accountant by profession, he is known for his analytical skills and holds 10 years of experience in Indian capital Markets research.

Individual Investors Member of Bombay Stock Exchange Mr. Ramesh Damani is a well known name among investors in India. A proponent of value investing, Mr. Damani has been tracking the markets for many years now and holds a distinguished investing record. Mr. Ranjeet Hingorani is also a value investor, and has a tremendous investing experience. He is a believer of Philip Fisher and Benjamin Grahams theory on investing.

Mr. Ramesh Damani

Mr. Ranjeet Hingorani

Wealth Research Manager

The names of the interviewees are coded (some respondents details are anonymous) and the codes are listed in Table 4.

12

The company name and profile of the interviewee is anonymous as requested by him.

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Chapter 3: Methodology TABLE 4 Keyword Mr Ramesh Damani Mr. Ranjeet Hingorani Mr. Vishal Jain Interviewee 4 Interviewee 5 Interviewee 6 Interviewee 7 Interviewee 8 Code RD RH VJ I4 (RS) I5 (RG) I6 (BP) I7 (AL) I8 (VS)

The interviewees were given a questionnaire before the interview to get to know if they understand the basic terminology and concepts used in the interview. A copy of the questionnaire is attached in Appendix 4. A sample of the questions was supplied in advance to all the interviewees but the discussion was open-ended and the questions were merely indicative of the areas to be covered. A copy of these questions is attached as Appendix 5 and the summary of the responses is presented in the Findings and Analysis section on page 62. For complete interview transcription, please refer to Appendix 7.

Table 5 segregates the participants on the basis of different criterion.

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Chapter 3: Methodology TABLE 5

Active Managers: 7 (RD, RH, I4, 15, I6, I7, I8) Passive Managers: 1(VJ)

Mutual Fund Managers: 3 (VJ, I5, I6) Individual Investors: 2 (RD, RH)

Stock Broking: 2 (17, 14) Other Institutional Investors: 1 (I8)

Mutual Fund Manager: Managing fund of Rs. 600 crores (~ 71m): 1 Rs. 6000 crores (~710m): 1 Rs. 10,000 crores (~ 1bn): 1 Investing funds for - Indian clients: 1 Foreign clients: 1 Both: 1

Stock Broking company participants: Small-medium sized company: 1 (I7) Large-sized company: 1 (I4)

Interviews: Face-to-face: 7 (RD, RH,VJ, I5, I6, I7, I8) Telephonic: 1 (I4) Tape-recorded: 5 (RD, RH, VJ, I5, I6) Recorded through notes: 3 (I4, I7, I8)

The interview was recorded by the taking of contemporaneous notes and audiorecording depending on the interviewees preference. Writing notes at the time can interfere with the process of interviewing, and notes written afterwards are likely to miss out some details (Britten, 1995). Therefore audio-recording was preferred. However, due to the reluctance of some interviewees, 3 out of 8 interviews were recorded through contemporaneous notes. Each interview lasted on an average for 60minutes with the exception of the telephonic-interview, which lasted for 20-minutes. This source of primary data was seen as essential in understanding the reasoning behind the investing behaviour, getting insight of various contradicting views on 57

Chapter 3: Methodology whether one can outperform the market or not and, if so, how?; identifying what investment strategy (active or passive) should be pursued by the investors; and other research questions.

During one of the interviews, for example, the interviewee misunderstood the meaning of the term passive investment strategy while answering, despite explaining the concepts before the interview was conducted. However, the interviewer could identify the misunderstanding and clarified the meaning of the term in reference to this study. Thus interviews also help in clarifying any misunderstanding on part of the interviewees in regards to the questions, concepts or theories used in research, which is not possible through a questionnaire. But also the few questions answered by the interviewee were not reliable as the question was not understood correctly because of the misunderstanding of the term.

The interviews conducted helped in getting below the surface of the topic being discussed, and uncovering new areas or ideas that were not anticipated at the outset of the research, which proved beneficial and added value in the research process. Thus, using the semi-structured interviews as the tool for getting answers to the research question proved to be the right choice and all the characteristics of these interviews discussed above seemed to be applicable in this research as well.

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3.5.2.4 Data Analysis

Figure 3 outlines the Data Analysis process

FIGURE 3

(Source: Author)

Detailed Explanation of figure 3 Once the interviews were taken they were subsequently transcribed. However, the interview transcripts produced a large volume of material, which made the data analysis a complicated process and it also turned out to be a time-consuming activity.

Content analysis was used for analysing the data. It is defined as a set of procedures for collecting and organizing non-structured information into a standardized format that allows one to make inferences about the characteristics and meaning of written 59

Chapter 3: Methodology and otherwise recorded material (Anonymous II, n.d.). This technique is popular for analysing qualitative data.

Once transcriptions were done, the data was subdivided and categories were assigned to the data. This process is called coding, defined as the process of translating raw data into meaningful categories for the purpose of data-analysis (Anonymous I, n.d.). The original recording of the interviews was revisited during coding of every interview to ensure that the true meanings of the participants responses are captured, even if the meaning is not implicit in the transcript of the interviews.

For analysis purposes a tabular format of the commentary made by the interviewee is also presented that provides answers to some of the research questions. The table, generated in results section, summarises the key observations arising from the interviews that have ramifications for the purposes for which the data was generated. However, in an effort to be holistic and provide a richer understanding of what emerged from the interviews, the tabular format is adopted but the commentary is extended to cover all key commentary made rather than excerpts. This will maximise understanding and minimise misinterpretations. This technique formally proposed by Locke (2001) has been replicated in other studies (see for example Crossan and Bedrow, 2003; Noble and Mokwa, 1999).

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3.5.2.5 Rationale for Interviews for research

Interviews with analysts and investors was considered appropriate given that there were a lot of issues to be considered, these issues were complex and the logic of the answers needed to be questioned, enabling the author to probe answers (EasterbySmith et al., 2002). In addition, a further advantage of conducting interviews was that it enabled a series of open questions to be put, whereas the questionnaire method would not have provided for follow up questioning or requests for elaboration.

Moreover, the nature of research also required data gathering through interviews, reasons have been discussed in the earlier section. Interviews are also a useful way of attaining large amounts of data quickly. It allows the researcher to understand the meanings that people hold for their activities (Marshall, 1999), which was crucial for this research.

3.6 Conclusion
To conclude, in the research the focus was on communication with the participants with a degree of dynamism. This reflects that there was a constant shifting with the changing phenomenon and context and this in turn brought about flexibility in research. In sum, the methodology used in this paper has used a very flexible approach and adequate care was taken in selecting data sources. Thus the entire approach and methodology used seeks to provide a comprehensive paper.

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Chapter 4: Findings and Analysis of study

CHAPTER 4: FINDINGS AND ANALYSIS OF STUDY

4.1 Introduction As
explained in the methodology section, interviews were conducted to find the

answers to the research questions and to test the propositions of this study. In this chapter, the results of the interviews will be described and will be concurrently assessed with regard to the relevant literature.

4.2 Findings to the Research Questions and Propositions

The notion that stocks reflect all the available information in the market is supported by many researchers and academicians (Fama, 1970, 1965; Malkiel, 1973, 1987, 2003; Kendall, 1953). However, others assert that stock markets are not efficient (Brealey & Myers, 2000; Blanchard and Watson, 1982; Lo and Mackinlay, 1999) and in fact argue that if markets would be efficient, no market would exist at all. In Indian markets also, several studies have demonstrated that markets are efficient in weak and semi-strong form and few of them showed that they are even strong form efficient. In Table 6 below, the findings to the first research question - Are Indian markets as efficient as other developed markets like US and UK? Why?, is presented using the commentary made by the interviewees. The interpretations of the commentary and findings are clearly highlighted in the table.

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Chapter 4: Findings and Analysis of study TABLE 6 How valid is the theory of efficient markets? Are Indian markets as efficient as other developed markets like US and UK?

Key Commentary made

RD: My understanding is that while markets are roughly efficient but they are not perfectly efficient and investors can take advantage of this gap between perfectly efficient and roughly efficient markets in order to maximise their returns. Indian markets are probably less efficient than other developed markets and that is because the equity cult has just now begun to take place, since mid-1990. Its an emerging market and in emerging markets typically the values are unknown, fund flow is not predictable. But as India is liberalising, the financial sector has also been liberalised, we are having lots of western influences. Indian markets are getting to a more efficient level.

I6: EMH assumes that two people think alike. It is good in theory but in practice it does not hold true. In real world information is analysed by people, who interpret it differently. Had computers carried out the analysis, the theory might have been true. The mere presence of brain in humans deviates markets from reaching an efficiency level because market comprises of people and people make the markets and each person interprets or views things differently. EMH is helpful in understanding markets and it can serve as a benchmark from where to start.

I4: India is a developing economy and for high growth markets like India, EMH does not hold true. India is not as efficient as the developed markets because it is an emerging economy. Markets of countries like UK and USA are saturated; the growth rates of companies are stagnant. However, in India, every now and then the returns of some sector suddenly grow at high rates and people who are able to identify them beforehand can outperform the market. Therefore, Indian markets are

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not as efficient as the developed markets. In fact, efficient markets are only possible in an ideal world, but not in reality. Reason being that there is always mismatch in expectations and this mismatch causes inefficiency in markets.

RH: I do not agree with the EMH. Market is a reflection of many people taking decision at the same time and they make those decisions on the basis of the information they hold, their interpretation of the information, their psychology, etc., which differs from person to person and hence all these factors together makes the market inefficient. However to some extent the markets are efficient because everyone has access to same information. So on the face of it youll find that the valuations are fair. Also there is no difference in the efficiency level of the stock markets in India and other developed markets because the people and their behaviour is the same and the greed exists everywhere. They have also gone through the dot.com boom and bust like India.

I5: Firstly about EMH, in theory it holds true, yes. But in terms of practicality, it is efficient over a longer period of time but in shorter term, say 3-6 months over even a year sometimes, market may not be efficient. India is a volatile market, and often times what happens is like there is not proper dissemination of information, it takes time for the market to understand that information. I think Indian markets will still take time to reach the level of developed markets like US or UK market. They are not as efficient as the markets of developed economies.

VJ: I agree with EMH to some extent. However complete efficiency is a utopian idea. In my view, Indian markets were not efficient 4-5 years back because the information was not disseminated properly. But today the regulations in the Indian markets have improved, information is disseminated as soon as it is available and the dissemination is also

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higher leading to markets becoming more efficient. The research on the markets has improved manifolds. Now, there are more researchers, analysts, and much more technically qualified people than earlier. Therefore the markets are much more efficient than they were few years back. And over a period of time, Indian markets would become more efficient.

I8: Indian markets are not efficient, in fact I think if efficient markets theory would have been true, no market would have existed. EMH is a reflection of an ideal world and ideal world does not exist.

Interpretations Indian markets, in fact, no stock markets are completely efficient. The
theory of complete market efficiency is only possible in an ideal world. Reasons for market inefficiency are mismatch of expectations, behavioural patterns, information not always fathomed correctly and above all the way information is being interpreted, in the sense that not all information is interpreted by computers, people are involved in assessing the information and people holding different perceptions assess information differently.

There is clear indication of difference in the efficiency level of developed and Indian stock markets. The main reason for this difference is that India is an emerging economy. Other reasons for the difference include Indian stock markets are not as well-researched as of developed economies, there is improper dissemination of information, it is a volatile market, fund flows are not predictable, the Indian economy is growing exponentially and there are many high growth-rate companies that are not present in developed markets.

The findings also indicate that as Indian markets are getting attention

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from foreign markets, the regulations are becoming restrictive, liberalisation is taking place in financial sector and markets are becoming well researched, the efficiency level is gradually integrating with the developed markets. But for this process to materialise fully, it would take some time.

The findings are in line with many studies that confirm that Indian stock markets are efficient in weak and sometimes semi-strong form, discussed in literature view. But they are not completely efficient. Findings also confirm that Indian stock markets are not as efficient as the other developed stock markets (like US or UK). Krishnaswami13 also agrees that the Indian stock markets lack liquidity and many Indian companies are thinly traded in markets controlled by powerful local brokerages (Knowledge@Wharton, 2006).

The answer to the first research question in Table 6 and the findings of the study yield an apparently significant result to the first research proposition that says: Complete market efficiency is a utopian idea. Markets cannot be completely efficient nor are they completely inefficient. The results indicate that no stock market can be completely efficient or completely inefficient. As Warren Buffett once commented, Id be a bum on the street with a tin cup if the markets were always efficient. The first proposition is therefore correct in context of this study.

Mukund Krishnaswami is managing director of Krilacon Group, an investment firm based in New York and Philadelphia.

13

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Chapter 4: Findings and Analysis of study Empirical evidences have suggested that market participants do not comprehend and interpret information correctly that causes inefficiency in the market (for examples see Jegadeesh and Titman 1993, Rajgopal et al, 2003). This study confirms this statement. Therefore, this discrepancy provides opportunity for smart investors to profit from and to understand that short-term price deviations should not cause panic or they should not make hasty decisions.

In the literature review it was indicated that several event studies have shown evidence of under-reaction in which the market response to new information appears to be too little or too late. The results from this study concur to this evidence. In context of global stock markets (including India) Mr. Damani quotes, information disseminates and there is immediate reaction but the final conclusion of that may sometimes take even years before the market understands what it holds.

Table 7 further summarises the findings along with the response of the interviewees on information dissemination and its interpretation.

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Chapter 4: Findings and Analysis of study TABLE 7 Is the information that is disseminated in the market interpreted correctly by the investors? Does the market price the securities correctly in short-term, medium term or longterm?

Key Commentary made

RD: Beauty is in the eyes of the beholder. Understanding the value of particular information and its implication on a company is an art, and not everybody can understand it atleast in the short-term. Market sometimes takes time to grasp the reality of particular information. Markets price the securities correctly in the long-run, it takes time for people to understand the full implication of the information

I4: Market prices the securities in a longer period. Inefficiencies would go away in a longer-term and there are no surprises in long-term which would deviate the market price from the intrinsic value.

VJ: I think information is interpreted correctly and its meaning immediately reflects in the prices. Even if the general public does not understand what lies behind, there are smart analysts sitting in the market who correct the price of the security if people misprice it. Market prices the securities correctly in medium-short term, because in short-term many factors causes deviations

RH: Information in the short-run and sometimes even in a longer period is not interpreted correctly. For e.g. sometimes the expectations of the market are so high that people actually misprice the securities, that is what I would call as overreaction bias. On the basis of just one piece of information people under-react or overreact and ignore the other factors that may be equally important in price determination. The market prices the security correctly only in the longer-run.

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I6: Over longer-term markets prices the securities correctly

I5: Markets price the securities correctly in Medium-long term. In short-term there might be fluctuations, there might be discrepancies in terms of pricing but in a long-run definitely markets price the securities correctly. Reason being that the information might not have been incorporated completely; there might be disbelief in terms of what is going on. There may be other external or international factors (psychological) like if there is a war going on somewhere and their markets and other markets are not doing well, people might expect companies and markets in India not to do well. In short-term there is discrepancy in pricing but in longer run it is corrected because the information sort of populates down (people understand the information and what lies behind it), other factors also settle down.

I8: There is a discrepancy. For example, the information that is disseminated may not be comprehended in the same manner as the company wanted to show. Each individual will understand and henceforth react in a different manner. In fact, existence of both the buyers and sellers in the market prove that same information is interpreted differently and there is rational and irrational action on the basis of that information. Markets price the securities in a longer-term. Short-term markets are driven by irrational investors. For example, external events like a bombing in UK will result in crash of Indian markets despite the fact that such an event actually has not affected the Indian economy or its industries and companies. It is just panic from investors or an opportunity for speculators to make profits by driving the market away from its fundamentals. However, in a longer-term the true picture will show and prices will reach their intrinsic value, their efficiency.

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I7: In short-term prices often deviates from their intrinsic value. However over a long-run the true picture is identified and hence markets price the security correctly.

Interpretations Generally believed that market participants take time to grasp the reality
of the information, sometimes it takes a long time to understand the fullimplications of the information. Information may not be comprehended in the same manner as the information-provider wanted it to, expectations formed before the information is disseminated causes distortion of true picture. In sum, information that is disseminated in the market is not always interpreted correctly by the investors. Its implication can be that it can provide opportunities for smart investors and analysts to profit from. On the other hand, VJs statement about the information dissemination varied from all the other respondents. He said that information is indeed interpreted correctly and even if some people do not fathom it correctly and misprice the stocks, smart arbitrageurs exist who bring the securities to their correct prices. Further research on the area is needed to find the validity of this argument in Indian markets.

Answer to the first question broadly answers the second part. General consensus is that markets prices the securities correctly in the long-run. In the short run, markets are sometimes driven by irrational investors who cause prices to deviate from their intrinsic values. External factors which actually do not have any effect on the companies may cause these deviations. Investors panic if information is not what they expected. All such factors lead the prices of stocks, in the short-term, away from their intrinsic value.

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Chapter 4: Findings and Analysis of study Results from Table 7 confirm the argument of Brian (1994) At any time there will be two sorts of operators in the stock market, one bull and the other bear, but they will rarely be in balance. When bulls predominate the market will go up, and when bears predominate the market will go down. The ratio of these two sets of people will vary according to their interpretation of various news items, both political and business, upon other investors, as well as their overall feeling about the economy in general and the stock market in particular.

The results from Table 7 also clearly substantiate the findings of Barman and Madhusoodan (1993) who found that stock returns do not exhibit efficiency in the shorter-to-medium-term though appear to be efficient over a longer run period. When the interviewees were asked, does the market price the securities correctly in shortterm, medium term or long-term, all of them answered that it does it in a long-run or medium-to-long run and that markets are not efficient in the shorter term. In the short-term many macro-factors like war in some part of the world or a terrorist attack in another country, which do not have much affect on the economy and stock markets, also affect the prices of the securities. There is a tendency to over-react to some piece of information amongst the investors and under-react to others. DeBondt and Thaler (1985, 1987) argued that investors tend to overreact to extreme price changes due to the human tendency to overweigh current information and underweigh prior data. I7 says people generally tend to forget the past and other factors that have an effect on the company and give so much weight to the current information that it leads the price deviation from its intrinsic value. The results from this study

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Chapter 4: Findings and Analysis of study concur DeBondt and Thaler findings, and this provides another reason for why markets are not efficient in short-term.

Benjamin Graham (1965) was therefore correct in suggesting that While the stock market in the short run may be a voting mechanism, in the long run it is a weighing mechanism. True value will win out in the end.

The results clearly indicate that in the short term several factors causes prices to deviate from their intrinsic value, however in a longer period all the shocks and surprises vanish and the price of a security reflects its true value. These findings generate important results for proposition 2 of this research that says: Stock markets price the securities correctly in long term. In other words, over a long-term the price of a companys shares reflects its intrinsic value. Proposition 2 has been tested and verified and the finding from this study shows that it is correct.

Table 8, below, seeks to provide an answer to the third research question.

TABLE 8 What investment strategy should be adopted by individual investors? Does their risk profile affect their choice of investment strategy?

Key Commentary made

RD: I believe in active strategy for investment. Passive investment strategy is good for people who actually dont have time to follow the

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financial markets, dont have time to think or read the Balance sheets, and meet and talk to the management of the companies. So it is a low cost way to take the advantage of the economic growth of a country, just buy the index and get market returns. And yes, the risk profile of an investor will also affect what investment strategy he wishes to adopt. A risk-averse person would prefer indexing, while someone who is less risk averse will go for active strategy.

I4: What investment opportunity should be adopted by investors actually depends on their risk profile. If you are a more risk-averse individual, you should go for passive investment strategy, while a riskneutral or less risk-averse person should go for active strategy. However, in a country like India, I think, they should go for active investment strategy because Indian stock markets are developing and in Indian markets abnormalities often occur which causes inefficiency and thus opportunities for active managers to profit from them.

RH: Individual investors who do not have expertise and understanding of analysing companies, markets and sectors can straight away go for indexing, because the expenses and cost to the investor is less and they will be much better off than many active investors. When market falls, active investors may lose much significant amount than passive investors. Risk profile of an investor may not necessarily affect his choice of investment strategy. A person who is risk averse, because he has made one correct decision in investing his risk taking capacity increases. He becomes intelligent and brave in his own eyes. And then he takes that additional risk that is disastrous. So risk profile for me is a relative term. When an investor is making money, for him risk becomes irrelevant and when he loses money he realises what he has done and becomes risk averse but then it is too late.

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I5: Active will generate better returns. Even a passive investor, when sees his returns are lower than markets, will eventually divert to active because of the nature of Indian markets, they are very volatile.

I8: I think that individual investors should adopt an active investment strategy broadly, but if they want stable returns and are risk-averse they should adopt passive strategy. Moreover, since the investors do not have access to information and resources to analyse and understand that information as well as the fund managers do, they should invest in the market through professional investors, rather than doing it themselves.

I7: There is low risk in passive investing, but not necessarily true in volatile markets like India. I would recommend active strategy because that is what investment is all about.

VJ: I think it should be a combination of active as well as passive strategy. Simply because there are periods when active fund managers outperform the market and indexing doesnt generate returns. And obviously the skill is there and that skill of active guys should be valued. However, because an active manager has outperformed the market this year doesnt guarantee that he will be able to outperform in the coming time. I dont want to take this risk. I might as well put my funds in an Index for 4-5 years and I believe in it because if our economy is going to grow, which it will, so obviously the large companies are going to benefit the most. I want to be invested in the best companies and that is reflected in the Index. I dont want to put my money with some fund manager who might be there today but might not be there tomorrow, who is performing today but might not be performing tomorrow. I dont want to make that call. Yes, definitely the risk profile of an investor makes a difference in his investment strategy. If the investor is risk-averse, he would probably

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prefer being with the index. He would not want 30-40% return that may not be stable; he is content even if he is just getting the market returns of say 20-25%.

Interpretations

There are divergent opinions on what investment strategy should be adopted by individuals; some suggest active strategy, some advice going through mutual fund channels only but through active managers. One interesting response was a combination of both active and passive. No one advised a pure passive investment strategy. Clear indication of risk profile affecting choice of investment strategy. A more risk-averse person would pursue a passive strategy and a less risk averse will follow active strategy. Two interesting perspective also arose. First is that risk profile affects the choice of strategy but a passive strategy may be more risky in volatile markets like India and second is that risk is a relative term, the more one earns the more risk taking he becomes.

Malkiel (2005) argues that - In recent years financial economists have increasingly questioned EMH. But surely if market prices were often irrational and if market returns were as predictable as some critics have claimed, then professionally managed investment funds should easily be able to outdistance a passive index fund and shows in his paper that professional investment managers, both in the U.S. and abroad, do not outperform their index benchmarks and provides evidence that by and large market prices do seem to reflect all available information. To the extent of Indian markets, the above statement and finding provided by Malkiel does not hold true. The results from this study show that passive (or index) funds are

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Chapter 4: Findings and Analysis of study not very popular in India and in fact there are examples of active funds that have beaten the market consistently. As Dey (2006) points out, there are not too many takers for such funds (passive) in India, even though the asset management company in question may be backed by the mighty HDFC (a leading and renowned asset management company in India).

Thus the findings from this study contradict the assertion of many researchers who agree with efficient market theorys implication that it is not possible to beat the market. In India, there are actively managed funds that comfortably outperform the index over longer time frames (over 3 years). This is because unlike the United States (or UK), India is a developing economy and many stocks are still under-researched. This gives fund managers several investment opportunities to outperform the index. So investors chasing performance still have a good reason to invest in active funds14. All the mutual fund managers in this study have agreed to this that in India, there are ample opportunities for active managers to outperform the index and they have been consistently doing it. Even other investors have confirmed this view.

Another reason for the unpopularity of index funds in India is costs. Although index funds in India have a lower expense ratio vis--vis their actively managed peers, they are not as cost-effective as their US counterparts when it is compared to their actively

14

This evidence is provided by Personalfn (a investment advisory company in India) in their article Index funds: Too expensive, published in 2005.

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Chapter 4: Findings and Analysis of study managed counterparts from the same fund house (Personalfn, 2005)15. Thus, the costs associated with passive funds are not low enough in India to get investors interested.

These findings provide an indication to the passive fund managers to develop their products in ways that will be attractive to customers. The findings from this study also shows that there is a need for awareness of indexing strategy amongst individual investors. Results also indicate that in the coming time, in India, passive strategy will gain popularity, as the markets will reach a more efficient level.

Table 9 provides evidence on whether overvalued/undervalued stocks exist or not.

TABLE 9 Do overvalued and undervalued stocks exist?

Key Commentary made

RD: Yes they exist and because they exist I am able to make money otherwise I would have been a poor guy, I would have been out of the market.

I4: Yes overvalued and undervalued stocks do exist. In fact it is corollary of the fact that markets are inefficient. Expectations differ in the market, which results in undervaluation and sometimes overvaluation of the stocks.

Motilal Oswal when asked in an interview if the market is reasonable valued answered, The market is never reasonably valued; it is either underpriced or overpriced16.
15

Refer Appendix 6 for the expense ratio of active and passive funds in India and in US.

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I7: Markets are often driven by greed and fear of the people, which causes stock prices to move beyond their intrinsic value causing overvaluation of stocks, as has been seen in 2000-2001 Internet bubble. Similarly when people suffer losses because of the mistakes they commit of buying stocks in highly overpriced market without understanding fundamentals, they are so scared of the market that it causes companies selling sometimes below their cash value. In 2002-2004, I have actually seen that the offices which used to be packed with traders and investors 2-3 years back had no one except the operators. Stockbrokers used to telephone their clients and convince them to come to the market atleast for a few hours. Being an analyst, I found some very good companies during that phase whose stocks were selling in the markets at unbelievably low prices and no one wanted to buy them. While 3 years back, people actually were paying up to say 50x the price to get the same company. Nothing went wrong with the company; it was still selling its products, generating profits and running its business. But it was the fear and over-pessimism that was guiding them. This is a clear indication of existence of overvalued and undervalued stocks.

I5: Yes overvalued and undervalued stocks exist all the time

I8: Yes, definitely overvalued and undervalued stocks exist in the market. Markets are like a pendulum which swing between the phase of overvaluation and undervaluation.

16

Motilal Oswal is the Chairman and Managing Director of Motilal Oswal Securities, which is amongst the top 5 broking houses in India. This comment is taken from a Newspaper article by Bhagat (2006)

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Interpretations

Common belief among participants that overvalued and undervalued stocks exist in the market. Difference in expectations, over-optimism and over-pessimism and fear and greed amongst investors and the recent Internet Bubble confirm that overvalued and undervalued stocks exist.

Finding from Table 9 and verdicts of interviewees show that it is possible to outperform the market, especially in India. Identifying undervalued and overvalued stocks can provide opportunities for investors to outperform the market. It requires skill and investment acumen to identify these opportunities, which is not possessed by everyone. But nevertheless, people who have that acumen can outperform others in Indian stock markets. RD remarked, People say that since nobody can beat the market why should I try. So the question is not this. Let me give you an example, in Mumbai say 3000 people play tennis everyday. Half of them lose and half win, so that doesnt mean that people who lose will give up trying. They have to get back and get their credit. I6 comments: not everyone can continue to outperform the benchmarks all the time. Even Warren Buffett underperformed for the brief period of technology boom. But then over a longer run, it is possible to beat the market consistently. I5 also commented I am admitting that it is not easy to beat the market especially with the changing scenario of Indian stock markets as they are being wellresearched, but the fact is it is not impossible either. The how part, i.e. how to beat the market, is discussed on page 94.

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Chapter 4: Findings and Analysis of study I5 quoted: Skill is an important factor that distinguishes an outperformer from others. VJ also commented on the presence of skill in Table 8 that implies that skill helps in selecting good investment opportunities. I8 quoted: your skills and ability to identify good opportunities are important in making investment-decisions. I7 stated that, If we actually contain to stick to our basics then only we will be able to beat the market through our skill through our vision. RH also agreed that vision and analytical skills of an individual that others do not have, distinct him/her from the average people and using this he/she can outperform the others. He further adds that To outperform the market a good judgement is required and that is matter of skill, which everyone does not possess. Skill plays an important role.

The above discussion and results from Table 6, 7, 8 and 9 and the subsequent discussion clearly demonstrate that it is indeed possible to outperform the market consistently but it requires distinct skill and investment acumen. These results verify proposition 3 that says: It is possible to outperform the market on a consistent basis and skill plays an important role in such performance. The chances of consistently outperforming the market are low, albeit possible. Thus the findings of this research confirm and verify the above proposition. Shiller (2001) also says that Success in investing usually involves some acquired skills in understanding the particular category of investment and in the strategy of dealing with it.

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Chapter 4: Findings and Analysis of study Table 10 provides results on whether the majority of markets participants in India are driven by short-term speculative motives or not? And also attempts to test the Research Proposition 4.

Table 10 Keynes pictures the stock market as a casino guided by animal spirit. He argues that investors are guided by shortrun speculative motives. They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short-run price movements. Is this statement correct in context of Indian markets?

Key Commentary made

RD: I think he is right. So I agree that stock markets act like a casino where people are looking for short-term fluctuations and not long-term value and it is there for their detriment. Globally investors behave the same way, when they come to the stock market they look at price and not value.

I4: I dont think it is completely true. Speculators do exist, but then there are people who want to stick to their decisions and are not speculating. People do take a longer term view. But like I said, traders also exist who carry out speculation.

I5: I think it is a fair comment and I dont dispute that. Very few people in the Indian markets are there for a long-run. Nobody wants to wait for their returns. People dont picture their stocks as investment.

People dont want to invest money but play with the market.

I6: Keynes picture of the market is absolutely correct, bulk of the

investments that is done in the market is done with the mindset of

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making short term profits and that is why people dont make money. People actually think it is a casino where cheap money can be made but believe me there is no cheap money in this world.

I7: Keynes made a fairly correct statement. In fact, this problem is more severe in Indian markets; everyone is here to make cheap money. Especially when the markets are on a bull run, you will find housewives, doctors, software professionals, bank clerks, credit managers investing in the stock market. In fact even my cook wanted me to recommend him stocks to put his money in. And believe me they dont understand a bit about the company they are putting their money in. It is actually like a casino for them. However, actual investors do exist, though sometimes even they are driven by this animal spirit.

I8: In regards to Keynes picture of the market, I think his explanation is correct and this happens in the market. But is this not what markets are for?

Interpretations General consensus that most of the market participants are driven by
short-term speculative motives in the Indian stock markets. Most of the people in India invest for the short-term; very few people actually are long-term investors. In fact even they are sometimes driven by the markets and indulge in speculation.

When the interviewees were asked to present their opinion on Keynes view of the stock market (see Table 10) all of them supported Keynes picture of stock market. Results from Table 10 verify the proposition 4 that states: Most of the people putting-in money in the stock markets in India are guided by the short-term speculative motives. Therefore, prices of securities often deviate from their intrinsic

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Chapter 4: Findings and Analysis of study value. However, findings also indicate that long-term investors do exist who pass the definition of investors provided by Graham that says, An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return and people indulging in the investment operation are investors. Operations not meeting these requirements are speculative (Graham, 2003; Graham and Dodd, 1934). Though such investors are very rare in the market and even they sometimes are sometimes susceptible to speculation.

RD gives a very interesting statement, Stock markets are vehicle of producing only long-term wealth. But people speculate and get in for adventure, but that is not the purpose of the market. You might be using it for different purposes and that is why you end up with bad returns and hard luck stories.

Table 11 generates the results on behavioural finance and irrational behaviour of the investors.

TABLE 11 Is Behavioral Finance (BF) important in making investment decisions? What irrational behaviour or emotional biases investors capitulate to, in India, that affects their investment decisions and also market prices and returns?

Key Commentary made

VJ: I think people have run out of ideas to beat the market and that is why things like BF are coming up. It is a fuzzy logic. There is a tip-behaviour in India. Without using their judgment

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and research people invest on the basis of tips from the market. Everyone in the market wants to make quick money, no one looks at it as investment. Greed drives people. All this is irrational behaviour.

RD: I think understanding

behaviour is important in

understanding markets and in making investment decisions. If you go to a store in sale and two shirts are selling for the price of one, you will buy more shirts because it is cheaper. But in stock market the reverse happens, when the market goes down people run away instead of buying more they buy less. While when prices go up all of them want to buy shares. At the bottom of the market when they should be buying they are too scared to buy while in bull markets people will pay any price to get stocks of the company that are hot/popular. Now that is irrational behaviour.

I5: It is fairly important because a lot of time what happens is that there generally is consensus in the market and the consensus normally is wrong. Examples - There is herd mentality on the streets. Suddenly when you see something doing well, everyone wants to pile on it. Then over-speculation, chasing stocks with no fundamentals at all just because someone on the street or your stock-broker has recommended you. Greed, I should not be left-out attitude.
People dont have time to analyse and get the information on the stock, because they have their own work and business to manage, so they just buy whatever is recommended to them. The attractiveness of the stock market is so overbearing that they cant afford to miss anything like that. And mind you losing an opportunity hurts you more than having actually lost money.

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I7: BF provides a platform to learn from peoples mistakes, to modify and improve their overall investment strategies and actually profit from identifying these mistakes. It is very helpful.
People show problems of self-control, and know that they may be unable to control themselves in the future. Investors get optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic amid downturns. Putting-in

money on tips, overconfidence, greed and getting emotionally attached to the shares are other examples of irrational behaviour seen in Indian markets. I8: BF is indeed very important in making investment decisions. One of the examples is herding behaviour, herding without understanding why they are getting into a particular sector and without understanding why they are buying stock of so and so company. Even rational investors and professional managers follow the crowd.

RH: BF is very important while making investment decisions. Since everyone is investing in the market and making money then why should I be left-out attitude exists. There is a tip-behaviour in the market, because no one wants to do the hard-work and still want to make money.

I4: Yes BF is actually very important and understanding behaviour can actually help us in not making the errors people generally commit in the market.

Interpretations Generally believed that behavioural finance is very important in making

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investment decisions. However, one respondent presented a contrarian view that it is a fuzzy logic and can cause trouble if decisions are based on it. To sum up the comments, behavioural finance is actually important and can provide a means for understanding what errors should not be perpetrated. The irrational behaviour of Indian investors outlined include herding, greed, investing on tips available in market without evaluating it, buying when markets are up and running away when markets are down without understanding the logic, over-speculation, overconfidence, lack of self-control and emotional attachment to the shares invested in.

In explaining the importance of behavioural finance Mayer (2001) argues that Many psychological biases are so persistent in so many individuals that it seems difficult that anyone could deny their existence.

The findings of this research agree with the statement that Behavioural finance essentially says that people are not the rational participants EMH makes them out to be. The study shows that market participants can and do act irrationally (Anonymous I, 2006) and supports Mayers statement. The explanations provided by behavioural finance theory and the involvement of psychological factors in stock markets cannot be ignored. Most of the respondents agree that understanding peoples behaviour and learning from their mistakes can actually assist investors in their investment decisions and help them in improving returns from their investments. However, one of the respondents comments that The explanation provided by the behavioural finance

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Chapter 4: Findings and Analysis of study theory is correct and one should try to avoid the general errors but further argues that I might invest according to behavioural patterns and some day it might bomb on my face. I dont know to what extent it would work, whether it is stable, whether it works in different scenario. Even if you try to understand people all the time, you are not always be able to outperform & outsmart them.

Mr. Parag Parikh17 agrees that behavioural finance is very important in making investment decisions and with its use once can get good returns from the market After an extensive study of the literature on behavioural finance, I believe that its perfect application could make you a successful investor making fewer mistakes (in Verma, 2004). He further adds, Simply put, standard economic theory starts with a flawed basic premise that the investor is a rational being who will always act to maximise his financial gain. Yet, we are not rational beings; we are human beings. Frequently emotions prompt us to make decisions that may not be in our rational financial interest. Behavioural finance is the study of how emotions and cognitive errors can cause disasters in our financial affairs. In stock markets, behavioural finance can help explain situations such as why we hold on to stocks that are crashing, ridiculously overvalue stocks, jump in late and buy stocks that have peaked in a rally just before the price declines, take desperate risks and gamble wildly when our stocks descend (in Lohande, 2004).

17

Mr Parag Parikh has studied behavioural finance at Harvard University and is the Chairman of Parag Parikh Financial Advisory Financial Services, India has been applying the concept of behavioural finance while investing in the stock market.

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Chapter 4: Findings and Analysis of study In regards to the proposition 5, the tests and results confirm that Behavioural finance plays a vital role in understanding investor behaviour and making investment decisions. But the second part of the proposition that states - With the use of explanations on investor behaviour propounded by BF theory, investors can improve their returns in the market does not generate consistent result. There are mixed views on whether behavioural finance theory can help the investors in improving their returns and outperforming the market.

4.2.1 Why are IIs not able to beat the market

Billions of dollars worth stocks are traded on Indian stock exchange18 every day. This is supported by a massive investment in research, trading infrastructure, communications and so forth. Analysts, money managers, fund managers use their expertise and spend a lot of time analyzing a stock, its industry and peer group to provide earnings and valuation estimates. In India, the opportunities for active managers to outperform the market are greater than the developed markets, as discussed earlier. But despite all this, only a handful of the IIs in India are actually able to beat the market consistently. The results and findings have generated reasons for this underperformance discussed below.

The results indicate that pressure from investors to give quick returns is the main reason why Mutual Fund Managers (henceforth FMs) and other IIs underperform. All the interviewees agree that the fund managers have to report daily Net Asset Value

18

National Stock Exchange of India (NSE) and The Stock Exchange, Mumbai (BSE) website

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Chapter 4: Findings and Analysis of study (NAV)19 of their funds, which causes pressure on them and they start investing in the momentum stocks or the so-called current hot sectors in the market. Figure 4 gives a model of how the pressure is created on FMs.

Figure 4

(Source: Author)

There are various funds available in the market and investors (clients) have many options to choose from. In the mutual fund industry in India, FMs have to report the NAV of their fund everyday as seen in Figure 4. Now due to this, a pressure is created on FMs to show performance everyday, otherwise their clients shift to other funds. This pressure causes them to invest in momentum stocks, which may even be
19

The performance of a particular scheme of a mutual fund is denoted by Net Asset Value (NAV) (source: www.sebi.com)

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Chapter 4: Findings and Analysis of study against their own judgement. I6 explains, Investors create pressure on fund managers and that is why they get into momentum stocks. RD comments, There is a funny business going on in the mutual fund industry. Its a very NAV driven industry and everyday the NAV is reported. Now stock market is not conducive to printing a NAV everyday, you have to look at this over a period of time not everyday. Now if you force yourself to look at NAV everyday, you are going to end up not making any money because you then tend to go with the stocks that are moving up. So the whole Mutual Fund business is structured, in my opinion, in a wrong fashion. Suppose if we buy a house, we dont check its value everyday although it may go up and down. You dont need to check your investments value everyday. Businesses perform and keep doing their work irrespective of what is happening on the Dalal Street20. They create new products, launch their marketing campaigns, and enter new markets and all this has nothing to do with the stock exchange. I6 also remarks The manner in which the money is invested is wrong. People investing money in stock markets want to generate short-term profits. But they will have to take long-term perspective. And I think this phenomenon is worldwide, however it is more prominent in emerging economies like India and less in developed economies. If in the short run a fund does not perform, investors withdraw their money from it and invest in other funds and so FMs are also pressurized to select sectors and stocks which will generate short-term returns and so they fail to show their performance. People will have to take a long-term perspective in stock markets. He further adds that, If the fund manager is not investing in the hot sector because his logic and judgement says not to and he underperforms compared to others, people
20

Dalal Street in India is analogous to Wall Street of USA

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Chapter 4: Findings and Analysis of study will think oh he has lost his touch and they withdraw money from his fund and invest in other funds. That FM might then think that my business is suffering, if I dont invest in the hot sector I will be losing customers and I will be losing money. So let me also participate in the sector. When this bubble will burst I will walk out. But no one knows when this bubble will burst otherwise no one will invest in the bubble.

Thus results show that FMs are more short-sighted under stronger pressures from their customers concerned with short-term performance. In fact one of the respondents even commented that I often trade too much because my clients demand short-term performance. Moreover the frequent trading that they indulge in increases their expenses as RD mentioned, people who frequently trade, every time they buy/sell they have to pay the brokerage, they have to pay extra for difference between bid-ask price, they have to pay transaction costs. Over time all these costs add up to huge amount, so the compounded return of the person who engages in one time buy/sell is much higher than who actively buys and sells. This frequent trading is also a result of sometimes pressure from the investors.

Another reason for their underperformance can be attributed to the fact that generally IIs do not have the authority to make trades in accordance with their own best judgments, which are often intuitive, that they must have reasons for what they do, reasons that could be justified to a committee. Their obeisance to conventional wisdom hampers their investment ability. But in making investment decisions, using ones own judgment can actually help investors to outperform others as has been

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Chapter 4: Findings and Analysis of study discussed earlier. IIs are not allowed to use their judgment and they therefore are not able to work to their best ability and not give performance. VJ commented: It is like the chicken and the egg problem. I mean even if the FM has guts to sit in the market with his portfolio even when it is underperforming and still believe in his philosophy, the thing is people should also have faith in his philosophy and judgement. But it does not happen. If his fund is underperforming his clients will shift to other FM and then he will not have the money to manage. At the end of the day, it is business. I might have a philosophy but I got to survive in the market.

The findings also show that IIs try to be jack of all trades, i.e. they try to be an expert in all the sectors and do not concentrate on areas that they understand. As I6 comments, Investors put pressure on FMs to perform every quarter and the FM actually comes under pressure to retain the market share and they start looking at everything and basically become jack of all trades and master of none. And in the process they become average people and an average person will give you average returns. So they need to focus on their strengths. This is the biggest problem in MF industry.

Findings also indicate that Institutional investors are not able to outperform the market also because: many schemes they put the money into are designed in a way that they are not supposed to beat the market. Their motive is to generate safe returns.

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Chapter 4: Findings and Analysis of study Out-performance is not the motive of many schemes. (This was highlighted by I8 and agreed by other interviewees.)

Herding behaviour amongst the IIs is another explanation to their underperformance. As I8 comments If a well-known FM has identified something, the others get into it, stories are built, hype is created and that sector becomes hot. This is a common mistake. In fact, at this point in time, smart FMs exist and make good returns while others just pile on into that stock and most of them end up losing money. VJ also agrees that herding behaviour exists and that is why IIs are not able to beat the market. Everyone is having almost same portfolio. VJ further adds, It is a business and at the end of the day I have to survive in the market. I have to get the money, pay salaries & bonuses. So its like flavour of the month like today, in India, the whole flurry of investors is into mid-caps stocks & funds.

The findings also show that most of the FMs and other IIs concentrate on mainly large-cap stocks. Some firms are more heavily followed by the analysts than others. The result is that they end up having similar portfolio, as VJ mentioned earlier. In fact, most of the interviewees agreed that most of the portfolios of IIs are replication of Index, only a small chunk holds different stocks. VJ also commented If you look at the portfolio of active FMs, 80% stocks they have in their portfolio are there in the Index. This would mean that he is just going to play around with 20-30% of the stocks in his portfolio to generate returns higher than the market-returns, which again is a big call he is taking. So eventually he is also going to give you index returns. Simply

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Chapter 4: Findings and Analysis of study because the psyche is that he also cannot deviate much from the index because of the risk that he might underperform. Everyone is looking at the Nifty21, so they have to hold the Nifty stocks also. If he is completely off the Nifty and his selection goes wrong he would be in trouble and he would not want to take that risk. So indirectly he is also tracking the index. RH quoted IIs are only comfortable with buying large cap stocks that is why they are over-researched. So rather than venturing into something that is unknown or less popular, they pile on large-cap stocks, and they do this because if they dont get good returns they can say that they bought a good company. So their returns are ultimately market returns as they concentrate on Index stocks. Thus, herding and concentrating on just segment of the market causes IIs to not generate returns higher than the market.

4.2.2 How can investors identify good investment opportunities

The findings provide very interesting and valuable advice on how to identify good investment opportunities and what errors not to commit to improve the performance in the stock market.

Firstly, in order to identify good investments it is important to start with ones own circle of competency, which means only invest in companies that you can really

21

Nifty is an index of prices of a group of fifty stocks listed on the National Stock Exchange of India.

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Chapter 4: Findings and Analysis of study understand and can evaluate with confidence. This idea was introduced by Philip Fisher22 and later championed by Warren Buffett (Hangstrom, 1997). RD says, The market specialises in 6000 stocks, and you can narrow it down to 5060 stocks that you understand and pick from them. So the odds of beating the market improve dramatically because you are already within the industry. So, for e.g., if you are a doctor, pick a pharmaceutical stock, you will be much better able to understand say this is the medicine that will be given to all the diabetic patients and has a huge potential. You understand which the best medicine is and which company makes the best medicines amongst all. So you should build circle of competency in order to outperform the market, and you should look within that circle of competency. You should not try to be jack of all trades and master of none. You should be focused to the area and sectors you have understanding and knowledge about. I6 commented: Only focus on companies and stocks which you understand, whose business, markets, products, and management you can understand. An example for this can be given of Warren Buffett, he is an activist, in 2000 he made a statement that I dont understand IT industry and therefore I dont invest in it. For a brief period his performance was down as compared to other active managers who invested in IT companies. But his performance again soared and the other managers actually lost tremendous amount of money. In those brief periods of excess, one has to be focused on his basics and only concentrate on what he understands rather than getting driven or tempted by others. Very few money managers, fund managers and other investors actually follow what Warren Buffett said. I dont understand IT, so I

22

Philip Fisher was a very successful stock investor, best known as the author of Common Stocks and Uncommon Profits.

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Chapter 4: Findings and Analysis of study wont invest in it. Very simple. I will only invest my money in what I understand, because if you continue to put your money in what you know better, you will do better than the others.

One of the most important aspects highlighted by all the respondents was that getting good returns from the market would require a disciplined approach, i.e. not to be driven by markets and sustaining from the short-term luring opportunities. All the interviewees stressed the importance of being disciplined in the market and also taking all investment decision with a disciplined approach. RD commented: Discipline is extremely important, not only in terms of price but also in terms of understanding valuations. People base their decisions on price and even professionals make that mistake. If the prices go up it is good and if it goes down it is bad, they dont understand valuations of a company. I6 quoted: Discipline has an important part in making investment decisions. You have to be disciplined while making investment in the stock market; you should not get carried away by the market. You have to know your limitations and work on those limitations. I8 commented: It is the ability that will always keep you ahead of the market. And you need to have a disciplined approach of investing. This discipline means not getting carried away by the market, resisting the temptation of generating highreturns in short-term, which is an important cause of all the FMs to underperform. Not following the herd mentality Just because everyone is doing it I should also follow the herd. They should only be venturing into industries and stocks which they understand.

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Chapter 4: Findings and Analysis of study Strong fundamental research is important to evaluate an investment, disciplined investment approach is required, ability to identify excesses is also needed both when the markets are up and down.

Another point highlighted is to time the market correctly, in other words when making purchase or sale decisions in the stock market, it is important to identify the right time to buy the stock and also to sell the stock. This would come with experience and also with understanding the valuations of the security. I5 commented: Timing is extremely important in making entry to and exit from the market. Many people say that we dont time the market its not possible to time the market. But in my view, it is difficult but you got to get it right. Otherwise what is the point in identifying something which everyone has got into. You got to get in early and be at the lead rather than a laggard because then you will only make index returns and not extraordinary returns. The idea is not only to get the sector right, but to get it at the right time because it is not easy to determine the turnaround.

Three of the interviewees remarked that their experience says technical analysis can sometimes help in identifying the entry and exit time in the market. I5 commented: From stock entry and exit point of view technical analysis is important. It does help you in selecting your entry and exit points. You cant go and select stocks on the basis of technical analysis. But having selected a particular company, you should go back and look at the charts and you can check if there is volume happening in that stock, is there some accumulation going on and such factors, what are the range in which you

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Chapter 4: Findings and Analysis of study can typically buy and if breaks a particular level then you need to be a little careful. So you can go back and check your fundamentals, if it still holds or not. So it is a good guiding tool but not from stock selection perspective. I8 also pointed out that: Technical analysis is a useful tool and can aid to time your entry and exit from the market. It has been seen that stocks follow a particular pattern. And once you have identified that you want to invest in X company, then with the help of technical analysis, you can decide when should you buy stock of X company and when should you sell it off.

VJ remarked: Fundamental also works at the end of the day you have to look at numbers. Similarly in order to time the market you also might need technical analysis. You might even need behavioural finance. So you need inputs from everything, and use those and the make your decisions. I dont think one thing works all the time. Dont base your decisions on just one thing. So you got to take inputs from everything, inputs from fundamental analysis, technical analysis, behavioural finance and your own judgment to identify good opportunity and evaluate it. RH commented: Nature of the business, capability of management, quality of the management, such factors should be taken into account while selecting stocks for investment. It is, therefore, important to understand fundamentals, technicals, behavioural patterns and other important factors when making investment decisions and also while identifying investment opportunities. It is also important to understand that when you are making an investment, you are buying a business, i.e. you are investing in a business not in the stock market.

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Chapter 4: Findings and Analysis of study A lot of reading is required to get the information and knowledge about the companies, sectors and other macro scenario that will help in selecting sectors and companies. RH remarks: You will have to read a lot, go through annual reports, find out companies which have consistently made profits and will be able to do so by looking how their management is, finding out what are their plans for the next 10 years. You need to envisage whether this business is going to be there in the next 10 years, what will future hold for this company. From these aspects you have to refine your research and select stocks of good companies. You have to get into the nittygritty of the balance sheet of past few years, understand the company and the sector it is in, understand its competitive position in the market, how good the product or service it is selling is, how good its research and development department is. And then finally you have to make the judgement whether the company is good or not and its product will remain in the market in the coming 10 years. There is no short-cut in life and you have to be patient to be able to consistently beat the market. You can create wealth only through taking a long-term perspective.

4.3 Findings in context with Literature

Malkiel (2005) argues that markets are indeed efficient and provides evidence that by and large market prices do seem to reflect all the available information. Fama et al (1969), assert that stock prices respond quickly to new information, and subsequently display no apparent strong trends following major events such as mergers, stock-splits or changes in firms dividend policies. The market appears to anticipate the

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Chapter 4: Findings and Analysis of study information, and most of the price adjustment is complete before the event is revealed to the market. However, the results present a divergent view. Security prices in Indian markets do not always reflect all the available information. In fact claims have been made that since markets consists of human and their emotions are associated with market movements, no security price can all the time reflect all the available information. This result is supported by Stout (2003) who asserts that Information that is easy to understand and that is trumpeted in the business media may be incorporated into market prices almost instantaneously. But information that is public but difficult to get hold of, or information that is complex or requires a specialist's knowledge to comprehend, may take weeks or months to be fully incorporated into prices.

A review of the literature and an overwhelming body of empirical evidences shows that it is not possible to beat the market, especially not so after considering the expenses incurred on the research and analysis. This argument is supported by many researchers and scholars (Malkiel, 2003, 2005; Damodaran, 2002). However, the results of this study appear to contradict this allegation. Results from Table 6, 7, 8 and 9 and the subsequent discussion clearly demonstrate that it is indeed possible to outperform the market and that too consistently. There have been instances of funds and even individual investors who have been consistently beating the market on an average. They may not to for a temporary period, but on an average they do outperform the market, both in India and other stock markets. Ippolito (1993, p.42) and Brealey & Myers (2000, p. 361) also note that some recent studies have found

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Chapter 4: Findings and Analysis of study that mutual funds outperform market indexes enough to offset their research and trading expenses.

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Chapter 5: Conclusions and Limitations of the study

CHAPTER 5: CONCLUSIONS AND LIMITATIONS

5.1 Conclusion A lot of body of evidences have shown that stock markets are efficient and it is not
possible to beat the stock markets consistently both in India and other global stock markets. Critics have however argued that markets are not completely efficient and there are examples of out-performance that cannot be ignored as mere chance. This study examined the market participants view on the efficiency level of Indian stock markets and the behavioural patterns of investors in India.

The study shows that Indian stock markets are neither completely efficient nor completely inefficient, as Higgins (1999) puts it, rather than being an issue of black or white, market efficiency is more a matter of shades of grey. In Indian stock markets, that have substantial impairments of efficiency, more knowledgeable and skilled investors can strive to outperform less-knowledgeable and less-skilled ones. Apart from skill and investment acumen, a disciplined approach in the market and self-control is also essential to be able to beat the market. As Blaise Pascal puts it, all of human unhappiness comes from one single thing: not knowing how to remain at rest in a room.

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Chapter 5: Conclusions and Limitations of the study Existence of overvalued and undervalued stocks is also found in the Indian stock markets along with presence of active funds that have consistently beaten the Indian stock market. A preliminary objective of the study was to find out the importance of behavioural finance and whether its application can help investors in India to improve their returns from the market. A review of the literature showed divergent opinions on the importance of behavioural finance in making investment decisions. However, the results show that behavioural finance is important and behavioural pattern of the market participants should be examined when making investment decisions. But its usefulness in improving market returns was questioned by one of the respondents but others consented to its usefulness.

The study documents the reasons for the underperformance of the institutional investors. The empirical results indicate that pressure from clients to give short-term performance causes an increase in the expenses of the IIs and is also the reason why they are not able to outperform the markets. Consistent with the theory, herding behaviour and emphasis on large-cap stocks are also the factors that contribute to their underperformance.

Finally, the study also gives insight on how to identify good investment opportunities in the market and what strategies should be followed by the investors. Insights derived from this study can help the investors improving their performance in the stock markets.

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Chapter 5: Conclusions and Limitations of the study

Although the results and findings of this dissertation are encouraging, they should be viewed in the context of the limitations discussed in the following section.

5.2 Limitations of the study and future research

Finality is death. Perfection is finality. Nothing is perfect. There are lumps in it (James Stephens)

Nothing is perfect in this world and although the results and findings of this dissertation are encouraging, they should be viewed in the context of the following limitations.

An observed limitation of this study is that the area of study is very subjective. It is difficult, for example, to test the behavioural patterns of investors in stock market, to test the reasons for - why the Indian stock markets are inefficient, or to test how investors can identify good investment opportunities. It is therefore recommended for future researchers to find out the ways to test and investigate the findings generated in this research. For example, I4 suggested that to find out the correct picture of ratio of speculators versus investors look at the statistics or delivery volumes in stock markets. Also, I think a data research and survey would be more appropriate to find the answer to this question and I am sure you can easily find this data.

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Chapter 5: Conclusions and Limitations of the study This study used Qualitative research technique that has its own disadvantages. Firstly, the word qualitative implies an emphasis on the processes and meanings that are not rigorously measured in terms of quantity. This creates problems of reliability as it is difficult to categorize descriptions into codes and themes (Silverman, 2001). As a consequence, the researcher might have found it difficult to link the specific questions to larger theoretical constructs to illuminate the bigger picture. There are chances of researcher getting lost in the line of exploration as she might have failed to see patterns or skewed the analysis in one direction or another. More formally, there is a probability of elements of researcher bias found in this dissertation.

Another limitation is the inaccuracy and unreliability of the comments of the interviewee as analysts try to defend themselves and present a rosy picture about the investment strategies they adopt. Since the discussion was subjective, the respondents might have answered whatever they thought at that time but they might not have had the knowledge about the subject. Some of the interviewees didnt know the answers to certain questions asked during the interview and speculated their response, which can be a question-mark on the validity of the data. In one of the interviews, when the question are Indian markets as efficient as other developed markets was asked, the interviewee answered I dont know much about the US and UK markets, but I think that Indian markets are not as efficient as the developed markets, which was actually speculation of the answer and may not be reliable.

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Chapter 5: Conclusions and Limitations of the study The researcher may misperceive what the researched wants to communicate. As a result, the information gathered may not be reliable. The possibilities like the respondent didnt tell the truth or uncovered few facts or the absence of complete set of recorded data may create a question-mark on the reliability of this study. Even when peoples activities are tape recorded and transcribed, the reliability of the interpretation of transcripts may be weakened by a failure to record apparently trivial, but often crucial, pauses and overlaps (Silverman, 2000).

The reliability of the results cannot be taken as concrete outcome since only eight interviews were conducted, as the study was to be completed during a specific time frame. A small sample is therefore another projected limitation of this study. Moreover, out of 8 people interviewed, only one of them was pursuer of passive investment strategy, rest others were all active managers. Therefore, answers may be biased and may not have presented the true/complete picture. However, the reason for such bias in sample selection was that, in India there is only one asset management company that invests only through passive strategy. Other Fund Managers who managed passive funds are sometimes also in-charge of active funds and identifying and accessing them had not been possible. Future research should consider multiple informants or multiple members of the research team at each business unit; more analysts, investors and researchers from different companies and adopting different investment strategies (active and passive) to offset single informants bias as well bias arising due to concentration on only active managers.

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Chapter 5: Conclusions and Limitations of the study In qualitative studies, one important way of verifying findings or establishing validity is to actually take transcripts or analysed results back to some of the interview participants, and ask them if this is really what they meant. However due to time constraints and reluctance of the interviewee for validating their answers, this approach for validating the answers could not be carried out. Thus, for future research it is recommended that the researcher validates the data collected in order to improve the validity of the research.

Another limitation of the study was that interview results required lots of interpretation from the comments made as it was not possible to frame direct questions on the topic in hand, moreover the limitations of taking an interview will also be present.

The study and results were based solely on interviews. The use of quantitative research methods and techniques may well improve the validity of the findings and are essential to avoid purely empirical exercises. For example to examine whether IIs trade frequently and actually take short-term perspective in the market, use of quantitative study would be helpful.

But as Leonard Cohen quoted: There is a crack in everything, that's how the light gets in

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Chapter 5: Conclusions and Limitations of the study This research may have shortcomings, but it can provide a platform for other researchers to find out the causes of inefficiency arising in the Indian stock markets, identify the behavioural aspects of market participants that can be used to correct the mistakes investors commit in the market, provide guidelines for investors on the investment techniques that should be adopted by them. Moreover, this research has made an attempt to uncover the above subject areas and can therefore help the investors (both individual and institutional) in their investment decisions. The outcome in the results and findings section can help them to identify the mistakes and irrationalities committed by them and the market, and how can they improve it.

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http://www.mises.org/journals/rae/pdf/rae10_2_2.pdf [Accessed on 30th June 2006]. Silverman, D. (2001) Doing Qualitative Research: A Practical Handbook. London: Sage Publications. Stout, L. (2003) The Mechanisms Of Market Inefficiency: An Introduction To The New Finance, Journal of Corporation Law. Vol. 28, pp. 635-669.

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References Stout, L. A. (2004) Inefficient Market and New Finance. Journal of Financial Transformation, Forthcoming Available at SSRN:

http://ssrn.com/abstract=729224 [Accessed on 30th June 2006]. Tamakloe, R. A. (2003) An investigation of market efficiency and volatility spill over : the case of the merging African equity markets. Unpublished Dissertation, MA Finance and Investment, University of Nottingham. Thorley, S. (1999) [Online] The Inefficient Market Argument for Passive Investing. Available from: http://marriottschool.byu.edu/emp/SRT/passive.html [Accessed on 30th June 2006]. Vaidyanathan, R. and Gali, K. K. (1994) Efficiency of the Indian Capital Market [Online], Indian Journal of Finance and Research. Vol. 5 [2], pp. 35-38. Available from: http://www.iimb.ernet.in/~vaidya/Capital-Market-IJFR.pdf

[Accessed on 30th June 2006]. Verma, V. (2004) Behavioural Finance as an investment concept, The Hindu Business Line [Online]. Tuesday, April 27th, 2004. Available from:

http://www.hinduonnet.com/businessline/blbby/stories/2004042700200600.htm [Accessed on 2nd Sept. 2006] Zheng, Z. (2005) From Rationality to Bounded Rationality [Online]. Available from: http://www.uwm.edu/~ziyu/AEP.pdf#search=%22who%20proposed%20emh%22 [Accessed on 2nd Sept. 2006].

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LIST OF APPENDICES

APPENDIX 1

LIST OF ANOMALIES IN EMH (pp. 124)

APPENDIX 2

PREDICTIONS OF EMH AND EMPIRICAL EVIDENCE (pp. 124)

APPENDIX 3

PROFILES OF INTERVIEWEES (pp. 130)

APPENDIX 4

QUESTIONNAIRE BEFORE THE INTERVIEW (pp. 134)

APPENDIX 5

PROPOSED INTERVIEW QUESTIONS (pp. 135)

APPENDIX 6

COMPARISON OF EXPENSE RATIO OF ACTIVE FUNDS AND PASSIVE (OR INDEX) FUNDS (PP. 140)

APPENDIX 7

INTERVIEW TRANSCRIPTS (pp. 141)

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APPENDIX 1

Anomalies in EMH:

A. Fundamental Anomalies
Value Effect: Value investing is probably the most publicized anomaly and is frequently touted as the best strategy for investing. There is a large body of evidence documenting the fact that historically, investors mistakenly overestimate the prospects of growth companies and underestimate value companies (Anonymous, 1999). Basu (1977, 1983) noted that firms with high price-to-earnings (P/E) ratios earn positive abnormal returns relative to the CAPM. He shows that stocks of companies with low P/E ratios earned a premium for investors during the period 1957-1971. An investor who held the low P/E ratio portfolio earned higher returns than an investor who held the entire sample of stocks. Many subsequent papers have noted that positive abnormal returns seem to accrue to portfolios of stocks with high dividend yields (D/P) or to stocks with high book-to-market (B/M) values (Schwert, 2001). Capaul, Rowley and Sharpe studied six countries from January 1981 through June 1992 and found that Value Stocks outperformed growth stocks on average in each country (Anonymous, 1999).

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Appendices Small Firm Effect: Some studies have shown that small firms (capitalization or assets) tend to outperform. Banz (1981) published one of the earliest articles on the small-firm effect which is also known as the size-effect. His analysis of the period 1936-1975 reveals that excess returns would have been earned by holding stocks of low capitalization companies. Supporting evidence is provided by Reinganum (1981) who reports that the risk adjusted annual return of small firms was greater than 20 percent (Russel and Torbey, 2002). Others have argued that its not size that matters, its attention and number of analysts that follow the stock (Anonymous, 1999).

B. Calendar Anomalies

January Effect: Stocks in general and small stocks in particular have historically generated abnormally high returns during the month of January. Rozeff and Kinney (1976) were the first to document evidence of higher mean returns in January as compared to other months. Using NYSE stocks for the period 19041974, they find that the average return for the month of January was 3.48 percent as compared to only .42 percent for the other months. Later studies document the effect persists in more recent years: Bhardwaj and Brooks (1992) for 1977-1986 and Eleswarapu and Reinganum (1993) for 1961-1990. The effect has been found to be present in other countries as well (Gultekin and Gultekin, 1983) (Russel and Torbey, 2002). Keim (1983) and Reinganum (1983) showed that much of the abnormal return to small firms occurs during the first two weeks in January (Schwert, 2001).

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Appendices Turn of the month effect: Stocks consistently show higher returns on the last day and first four days of the month. Frank Russell Company examined returns of the S&P 500 over a 65 year period and found that U.S. large-cap stocks consistently show higher returns at the turn of the month (Anonymous, 1999). Hensel and Ziemba (1996) presented the theory that the effect results from cash flows at the end of the month (salaries, interest payments, etc.). Ziemba (1991) finds evidence of a turn of month effect for Japan when turn of month is defined as the last five and first two trading days of the month. Hensel and Ziemba (1996) and Kunkel and Compton (1998) show how abnormal returns can be earned by exploiting this anomaly.

The Weekend effect or Monday Effect: Monday tends to be the worst day to be invested in stocks. Average return on Mondays is very small, in contrast with that average return on Fridays (or Saturdays). Prices tend to rise on the last day in a week. The Price of the smaller firms shows greater changes in the weekend effect (Sato et al, n.d.). French (1980) analyzes daily returns of stocks for the period 1953-1977 and finds that there is a tendency for returns to be negative on Mondays whereas they are positive on the other days of the week. He notes that these negative returns are "caused only by the weekend effect and not by a general closed-market effect". A trading strategy, which would be profitable in this case, would be to buy stocks on Monday and sell them on Friday (Russel and Torbey, 2002). Several other studies confirmed this anomaly.

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C. Other Anomalies
Intraday Effects: On all days without Monday, prices rise during first 45 minutes. Returns are high near the end of the day, particularly on the last trade of the day. The day-end price changes are greatest during last five minutes, have been observer in experimental markets. Thaler (1992) also said a part of these phenomena can be explained by the structural and institutional reasons such as 1) the difference of duration when a market is closed and 2) the special duration related to a settling day.

The Weather: Few would argue that sunshine puts people in a good mood. People in good moods make more optimistic choices and judgments. Saunders (1993) shows that the New York Stock Exchange index tends to be negative when it is cloudy. More recently, Hirshleifer and Shumway (2001) analyze data for 26 countries from 1982-1997 and find that stock market returns are positively correlated with sunshine in almost all of the countries studied (Russel and Torbey, 2002).

Announcement Based Effects: Price changes tend to persist after initial announcements. Stocks with positive surprises tend to drift upward, those with negative surprises tend to drift downward. Some refer to the likelihood of positive earnings surprises to be followed by several more earnings surprises as the "cockroach" theory because when you find one, there are likely to be more in hiding (Anonymous, 1999). Haugen (1999) argues that the evidence implies that

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Appendices investors initially underestimate firms showing strong performance and then overreact. DeBondt and Thaler (1985, 1987) present evidence that is consistent with stock prices overreacting to current changes in earnings. They report positive (negative) estimated abnormal stock returns for portfolios that previously generated inferior (superior) stock price and earning performance (Russel and Torbey, 2002).

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APPENDIX 2

(Source: Breechey et al, 2000)

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APPENDIX 3

Interviewees Profiles

Mr. Ramesh Damani A member of Bombay Stock Exchange, Mr. Ramesh Damani is a well known name among investors in India. An MBA from California State University, Mr. Damani is also a frequent commentator on financial issues on CNBC and Star News. A proponent of value investing, Mr. Damani has been tracking the markets for many years now, has tremendous investing experience and holds a distinguished investing record. Email: rsdamani@hotmail.com

Mr. Ranjeet Hingorani A Wealth Research Manager, Mr. Ranjeet Hingorani is also a value investor, and has a tremendous investing experience. He is a believer of Philip Fisher and Benjamin Grahams theory on investing. Mr. Hingoranis value investing has generated him good returns from the market over the years. Email: hingo@sancharnet.in

Mr. Ravi Gopalakrishnan Mr. Gopalakrishnan is Portfolio Advisor to Hudson Fairfax Group (HFG), a US based investment firm focused on sponsoring and promoting India-related investments. He has 14 years of experience in the Indian capital markets. He provides exclusive non-discretionary investment advisory

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Appendices services to HFG. Mr. Gopalakrishnan has a broad and successful background in India equities, including value and growth investing in both large and mid capitalization stocks. His experience includes: Formerly Portfolio Manager at Principal PNB Asset Management Company and Sun F&C Asset Management, where he ran the Sun F&C Value Fund and the Resurgent India Fund; Eight years of experience in market strategy and research for UBS and Unit Trust of India Email: rgopal@hudsonfairfax.com

Mr. Vishal Jain - Mr. Jain is Vice President Investments and Fund Manager to Benchmark Asset Management Company, India, the only asset management company that purely invests through indexing. He holds a B.Sc. in Statistics and a MBA and has 8 years experience in Indian capital markets. He was previously with the Credit Rating Information Services of India Ltd. (CRISIL), India's premier rating agency, where he was part of the Capital Market group. He was then involved in setting up India Index Services & Products Ltd (IISL), a joint venture of CRISIL and NSE At IISL, he was also involved in promoting indices for the use of higher applications like Index Funds, Futures and Options. Email: vishal@benchmarkfunds.com

B. P. Singh Mr. Singh is the Managing Director of Atlantis Investment Advisors India Ltd and the Portfolio Adviser to the Atlantis India Opportunities Fund.

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Appendices Atlantis is a leading asset manager, specialising in Asian equities. Mr. Singh joined Atlantis from Deutsche Asset Management. He was Fund Manager of the Deutsche Alpha Equity Fund and the Deutsche Investment Opportunities Fund. Prior to this, BP Singh was Head - Equity Research at SSKI Securities, a premier brokerage house in India. He was directly responsible for India strategy and the Pharmaceuticals, Media and Biotechnology sectors. Before joining SSKI, BP Singh was Director - Research at UBS Warburg. He earned his MBA from SP Jain Institute of Management & Research at Mumbai and Bachelor of Technology (Chemicals) from University Department of Chemical Technology (UDCT) at Mumbai. Email: bpsingh@atlantis-investment.com

Mr. Rajesh Singhal Mr. Singhal the Investment Advisor and Portfolio Manager of a distinguished company.

Mr. Vinit Sambre - Mr. Sambre is the Product Analyst and Assistant Vice President of Global Private Client division of DSP Merrill Lynch. He is a Chartered Accountant and offers investment advice to the private client group. Email: vinit_sambre@ml.com

Mr. Ashok Lunawat - Mr. Lunawat is the Research Head of Arihant Capital Markets Ltd, a leading stock broking firm in India. A Chartered Accountant by profession, he is known for his analytical skills and holds 10 years of experience in Indian capital Markets research. He has been continuously searching for fundamental

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Appendices stocks with low valuations, quality management and excellent business model and has provided with some very good investment advice over the years.

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APPENDIX 4

Questionnaire:
FOR RESEARCH PURPOSES ONLY

Please answer the following:

YES

NO

Do you know what is Passive Investment Strategy (or Indexing)?

Do you know what Active Management Strategy is?

Do you what is does the term efficient capital markets or Efficient Market Hypothesis means?

Do you know what Behavioural Finance is?

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APPENDIX 5

Proposed Interview Questions:

1. (i) Do you agree with the EMH? (ii) To what extent do you think the theory holds true? (iii) Do you think that it is possible to beat the market? If yes then can you please explain how it is possible? (despite so many research confirming that except a very few people, most of the analysts and investors have not been able to beat the market). (iv) Empirical evidences prove that passive investment strategy are better and more beneficial than active investment strategies because as the markets reach efficiency the cost incurred (time and money) in discovering the strategies to outperform the index outweighs the benefits received from them. Is this true? (v) Do you think that Indian stock market is as efficient as the capital markets of other developed countries like US or UK? Why?

2. What investment strategy do you think investors should follow?

Active or

passive? (considering the evidence that cost involved (both time and money) in

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Appendices pursuing an active management strategy outweighs the benefits and Money Managers are not able to beat the market)

Why? What factors do you think should be taken into account? Does the risk profile of an investor make a difference?

3. Institutional Investors: - Many researchers have proven that nearly all mutual funds and other institutional investors fail to beat the market on a consistent basis and that they underperform the market. In most of the instances, when they actually are able to beat the market, the costs incurred in their research and other expenses wipe-off the benefits. Can you explain the reasons for this? Or provide evidence when a fund or a company has been able to outperform the market over a consistent basis? - Which types of stock (large-cap, mid-cap, small-cap) do you think Institutional Investors concentrate on? Why is that?

4. Investing for the long term means judging the distant future, judging how history will be made, how society will change, how the world economy will change. Reaching decisions about such issues cannot proceed from analytical models alone; there has to be a major input of judgment that is essentially personal and intellectual in origin. That is to say that long-term investment involves making ones own judgement about the future state of economy, company and the industry for prospective investment.

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Appendices Technical models, financial statements and other analytical statements do not suffice in making investment decision Do you think this statement is correct? Are subjective issues important in evaluating investments? Can you further elaborate this point from your perspective and give an example, from your own experience, when you identified a particular investment opportunity, long before it was popular in market and also detail on that.

5. How important is Behavioral Finance in making investment decisions? (i) Can you provide some examples of investor behaviour (irrationality per se like herding behaviour, over-pessimism or over-optimism) that causes inefficiency in the market from the Indian stock market perspective? And its Cause and effects? (ii) Are the explanations provided by the theory of behavioural finance regarding the efficiency of markets and behaviour of investors realistic? Examples of some of the argument and investor behaviour asserted by Behavioralists: When a market is moving up or down, investors are subject to a fear that others know more or have more information. As a consequence, investors feel a strong impulse to do what others are doing. Here, for example, is a good description of herding - Two restaurants face one another on the main street of a charming Alsatian village. There is no menu outside. It is 6:00 PM. Both restaurants are empty. A tourist comes down the street, looks at each of the restaurants, and goes into one of them. After a while, another tourist shows up, sees how many patrons are already inside by looking through the stained glass windows - these are Alsatian winstube and chooses one of them. The scene repeats itself, with new tourists checking on the

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Appendices popularity of each restaurant before entering one of them. After a while, all newcomers choose the same restaurant: they choose the more popular one irrespective of their own information (iii) Are they correct from the perspective of Indian stock market? Can you further provide some examples of Investors behaviour that may be categorized as irrational or that causes the market to deviate from being efficient?

(iv)

Keynes pictures the stock market as a casino guided by animal spirit. He argues that investors are guided by short-run speculative motives. They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short-run price movements. What is your view about the Keyne philosophy and why?

6. Do you think that markets price the securities correctly: - in short-term? - in medium-term? - in long-term? Why?

7. Do you think that as soon as some information regarding a security is disseminated in the market, it is reflected in the price? Do stock market participants fathom the information correctly and act rationally or there is a discrepancy?

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8. Do you believe in the existence of overvalued and undervalued stocks as against the many researchers and investors who think that there is no such thing in the market, and it is just a way of fooling investors?

9. How do you think should investors identify good investment opportunities?

-----------------------------Thank you for your time and patience----------------------------

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APPENDIX 6

Comparison of Expense ratio of active funds and passive (or index) funds:
Expense ratio of Funds in United States of America
Fund name FIDELITY SPARTAN 500 INDEX VANGUARD 500 INDEX FUND FIDELITY CAPITAL APPRECIATION VANGUARD GROWTH & INCOME
(Data sourced from fund house websites)

Management style Index Index Active Active

Benchmark index S&P 500 S&P 500 S&P 500 S&P 500

Expense ratio 0.10% 0.18% 0.94% 0.42%

Expense ratio of Funds in India

Fund name FT INDIA INDEX NIFTY FT INDIA INDEX SENSEX HDFC INDEX FUND (NIFTY) HDFC INDEX (SENSEX) HDFC INDEX (SENSEX PLUS) FRANKLIN BLUECHIP HDFC EQUITY FUND Management style Index Index Index Index Index Active Active Benchmark index S&P Nifty BSE Sensex S&P Nifty BSE Sensex BSE Sensex BSE Sensex S&P CNX 500 Expense ratio 1.00 1.00 1.50 1.50 1.50 1.90 2.02

(Source: Personalfn, 2005)

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APPENDIX 7
Interviewee
Mr. Ramesh Damani 14 Mr. Ranjeet Hingorani I5 I6 I7 I8 Mr. Vishal Jain

Page Number
141 149 152 158 167 172 174 179

Interview Transcripts:
1. Mr. Ramesh Damani
Do you think markets are efficient? What is your view on EMH in context of Indian markets? Do you believe in active investment strategy or passive investment strategy? My understanding is that while markets are roughly efficient but they are not perfectly efficient and investors can take advantage of the gap between perfectly efficient and roughly efficient in order to maximise their returns. Indian markets are probably less efficient than other developed markets and that is because the equity cult has just now begun to take place, since mid-1990s. Its an emerging market and in emerging markets typically the values are unknown, fund flow is not predictable. But as India is liberalising the financial sector has also been liberalised, we are having lots of western influences and western brokerage houses coming here telling us how to understand the markets, so we are getting to a more efficient level. But as this bull market will demonstrate to you that while the Index is up three times from bottom to top individual stocks are 15x or 20x, which clearly is not possible in an efficient market. So yes there are stock picking opportunities for investors in India, which would not be possible in a completely efficient market. Broadly I do not think perfectly efficient markets exist. Investors in market swing between fear and greed, there is a kind of herd mentality going on, everyone wants to pile on to the most popular stocks, stocks that are hot are in conversation in parties. So there will be opportunities for savvy investors to outperform the market because of such behaviour. Obviously it is not possible that they buy and immediately sell and get good returns. But for patient investors, for value investors, almost in every stock

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Appendices market in the world over periods of time youll find stocks that are irrationally priced, either undervalued or overvalued. People have different reasons to come to the market. And my theory is that market gives them exactly what they want in life. A lot of people want excitement in life. So they want something to do everyday. In most professions, activity is a positive and inactivity is a negative in terms of value. In stock market it is actually reverse. Inactivity generates value and activity does not conduce to better returns. Someone who bought Coke 10 years ago didnt really have to do much; the value compounded through that holding gave him humongous returns. So people think that the more active they are, i.e. the more trading they do, the better the returns will be. But history has shown that activity is actually negatively related to returns. People who frequently buy and sell, every time they buy/sell they have to pay the brokerage, they have to pay extra for difference between bid-ask price, they have to pay transaction costs. However, a person who invests for long-term, value investor, he has to pay all the costs only once, no capital gains tax and dividends accrue. Over time all these costs add up to huge amount, so the compounded return of the person who engages in one time buy/sell is much higher than who actively buys and sells. And for the person who engages in frequent trading needs a new idea every week, while people who invest for a longer period need only one great idea when they buy a stock. So over a long-run, long-term investment is better approach and also the costs are lower in it. Why do people do that? Because they enjoy going to the parties and saying that we bought the most popular stock or they enjoy saying that we are in the sensex stocks, that has gone up that day. And so they mess up. One should go to the financial market for long-term investment, should go for longterm wealth making and buy infrequently and with lot of conviction. Just as Rome was not built in a day, great stocks do not give returns in a quarter or a year. It takes time for the business to unfold, to get mature and to build the proverbial mode for the competition. And the thing is people dont understand these basic dynamics. They approach the market from various different points of view, not just from the point of generating wealth and the market then gives them just that. Thats the reason why so many people loose money in the market, and thats why they make such hard luck stories. They would say, I made so much money but I lost it all and I will never go back to the market. All this is because they dont understand the fundamental dynamics on which the markets operate. What we look when making investment decisions or buying a stock, what we call as value-investing, is we tend to look at the absolute market caps or see what a private party would pay to purchase the business or the company. Would it pay more than the market capitalisation of the stock or less than the market-cap. As long as we understand that the market is treating the stock relatively low compared to its private market value, we are happy to own the stock, despite the fact that the stock has doubled or quadrupled, or the PE may have exploded to 50 or other such arbitrary factors. So the approach to investing should be buy and hold and do a careful analysis

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Appendices before purchasing the company, which involves holding a vision and trying to look at the future and also requires skills. If you put it in the context of active and passive investment strategies you are saying, I believe in active strategy for investment. It is my job as an investor to allocate my capital and I take it very seriously. Passive investment strategy is good for people who actually dont have time to follow the financial markets, dont have time to think or read the Balance sheets, and meet and talk to the management of the companies. So it is a low cost way to take the advantage of the economic growth of a country, just buy the index and get market returns. But there are classic examples where I can tell you when passive investment got people in trouble is, for example when the Dow Jones Index hit 1000 for the first time in 1962 or 64 and it didnt come back to 1000 Index level until 1982, so for the period of almost 20 yrs if you were a passive investor in Dow you got no returns, but even during that period there were stocks and companies which did well in the stock markets. Take our own Indian markets, in 1992 the Sensex hit 4500 level for the first time, it did not cross that level decisively until 2004, so for the period of 12 years, a passive investor basically did not get any returns from his investment. So the trick in the stock market, whether it is passive investing or active investing is to buy value, is to buy things when they are cheap. The sensex at 4500 level in 1992 was not cheap, but in 2004 4500-level was cheap. So the trick in the stock market is to buy 1Rs for 50paise.

How would you find out whether a stock is cheap or not? I think it comes from years of experience in the market; the key factor is to look at how the market is valuing the stock and what in your estimation is the value of that business or the company you are buying. There are more than 6000 stocks traded on the exchange everyday and clearly no one can be an expert in all the stocks. But if you segment the market and if you say, for example, that I am a banker and I am going to look at the banking stocks because I understand that sector or I am in the construction business so I am going to focus on construction-related business. Certainly then the playing field is levelled to your advantage. Most famous question is that how can you beat Sachin Tendulkar23 and the obvious answer is that that you play nothing else but cricket. So should therefore play to your speciality. The market specialises in 6000 stocks, and you can narrow it down to 50-60 stocks that you understand and pick from them. So the odds improve dramatically because you are already within the industry. So if a doctor picks a pharmaceutical stock, he will be much better able to understand that oh this is the medicine that will be given to say all the diabetic patients and has a huge potential. He is already a doctor and he understands which the best medicine is and which company makes the best medicines amongst all.

23

Sachin Tendulkar is one of the famous cricket players in the world.

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Appendices So you should build circle of competency in order to outperform the market, and you should look within that circle of competency. You should not try to be jack of all trades and master of none. You should try to look at a very well-defined specialised area of the stocks you want. You should be focused to the area and sectors you have understanding and knowledge about.

Institutional Investors and MF Industry So much research conducted in the market by so many analysts, so price already reflects about the present and even what is going to happen in the future about the company. What is your view on this statement? See there are two questions, people say that since nobody can beat the market why should I try. So the question is not this. May be in Mumbai 3000 people play tennis half of them loose and half win, so that doesnt mean that people who lose will give up trying. They have to get back and get their credit. A lot of value investors follow Graham and Buffetts school of investing and a lot of them have beaten the market consistently over time. The MF industry is very strange animal. Its a very NAV driven industry and everyday the NAV is reported. Now stock market is not conducive to printing a NAV everyday, you have to look at this over a period of every bull market cycle or every bear market cycle from 2-3 years perspective. Now if you force yourself to look at NAV everyday, you are going to end up not making any money because you then tend to go with the stocks that are moving up. So the whole Mutual Fund business is structured, in my opinion, in a wrong fashion. That is why you see that over a 14 years period no one has beaten the S&P (Standard and Poors). There was one person, who could do it for 13-14 years, but he also fell flat, that is Bill Miller in America. So it is very hard to beat the market because of the way MF industry is structured. But individual investors dont face that problem. They can be inaudibly patient; they dont have to match their returns to say S&P or the Dow all the time. (12:30) I think the MF industry has to come up with a different way to benchmark their returns. It may be different with a closed-end fund, but any open-end fund, which is NAV driven has to face this problem because the MF manager is almost compelled to buy the bad stocks but only because they are performing. If you dont increase the NAV money doesnt come to you and if money doesnt come to you, your returns go down. So its a vicious cycle that is going on. The NAV goes up you will be buying bad stocks, more money comes in because people are attracted by the percentage of appreciation 13:10. And in the long run it is the single most detrimental factor for the financial market, but they havent learned that yet.

Do MF managers concentrate on only a particular kind of stock, say large-cap or mid-cap and completely ignore one side of the market?

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Appendices Again it is a peculiarity problem. But its not completely true because now, for example, there are small-cap funds, sector funds and other funds concentrating on mid and small-cap stocks. But generally the sheer size of the money they have make them put the money in the large cap funds because they cannot get a meaningful quantity of a small cap stock. So yes they want liquidity and they want inhibitions. So there is this funny business going on in the MF industry. Individual investors dont have that problem because they are investing their own money. If the stock performs well liquidity will automatically appear in that stock and individual investors can wait for that. So the trick is to get the stock right. What I believe in, like many other value researchers is, we test that if we buy a stock today and the markets close for 10 years would we still be willing to hold that stock? If the answer is yes then only we decide to buy a particular stock. Because good businesses create value over time. Suppose if we buy a house, we dont check its value everyday although it may go up and down. Similarly for five ten years it is ok, you dont need stock quotation everyday. But this business is created in such a way that people think that unless the stock is not quoted well in the Evening Press the company is not performing well or is not doing anything. But this is wrong. Businesses perform and keep doing their work irrespective of what is happening on the Dalal Street (it is analogous to Wall Street of USA). They create new products, launch their marketing campaigns, and enter new markets and all this has nothing to do with the stock exchange. Over time the yes markets prices the securities correctly, as Warren Buffett once quoted, in the short run the market is a popularity machine but in the long run it is a weighing machine. As it is generally said that it is not always the most popular girl who ends up getting married to a smart guy. Look for different things at different stages in life. In the short-run market goes haywire and there is a bunch of other things going on which causes prices to deviate from their fundamental value. So in the long run market will reflect the true value of the businesses.

How would you be able to outperform the market when the information is available to everyone and they might have acted upon it? Markets work on difference of opinion, for every buyer there is a seller and viceversa. In fact most of the people start investing in the markets when the markets are up and there is a popular saying in the Wall Street that when the public gets smart, the smart get out. In the bear market, when markets are at bottom no one is talking about stocks and when markets are high everyone is in the stock market. When markets are up the stock market investors are the most popular people and when markets are down everyone talks about Bollywood in India. Despite knowing this, for some strange reason it always happens the same way. In fact the stock market would not exist if everyone behaves rationally; the fact is we know people behave irrationally. We may tell them in lectures, give them presentations, tell them through books, explain to them the mistakes they are making, but unfortunately the stock market is a place where people dont use their

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Appendices rational senses. Say for example if you go to a store in sale and two shirts are selling for the price of one, you will buy more shirts because it is cheaper. But in stock market the reverse happens, when the market goes down people run away instead of buying more they buy less. While when prices go up all of them want to buy shares. To perform well, people will have to break that psychological mind-set they are in but history shows that it will not happen.

How important is Behavioral Finance in making investment decisions? Can you provide some examples of investor behavior that causes inefficiency in the market from the Indian stock market perspective? And its Cause and effects? I think understanding behaviour and psychology is important in understanding markets and in making investment decisions. People repeat the same mistakes and if I can profit from it then I will do it. At the bottom of the market when they should be buying they are too scared to buy because previously when markets were up they bought stocks at crazy prices and lost money. So now they are too scared too buy. There are companies in the bear markets that trade below their cash value and yet people wont buy that stock while in bull markets people will pay any price to get stocks of the company that are hot or are the next big thing in the market. Now that is irrational behaviour. This is the classic mistake people make, not doing their home-work, not understanding the nature of the market, getting into areas out of their circle of competency like doctors buying technology stocks when they dont understand the ABC of the sector or the company they are buying shares of. Stock markets are vehicle of producing only long-term wealth. But people speculate and get in for adventure, but that is not the purpose of the market. You might be using it for different purposes and that is why you end up with bad returns and hard luck stories. But if you come with the purpose of generating long-term wealth and make long-term investments then only you will generate favourable returns and will be able to beat the market.

So you think discipline is important factor when you are in the stock markets? Yes it is extremely important, not only in terms of price but also in terms of understanding valuations. People base their decisions on price and even professionals make that mistake. If the prices go up it is good and if it goes down it is bad, they dont understand valuations of a company. But the thing is sometimes when the stock price goes down for some reason, it becomes more attractive but people dont understand that.

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Appendices Keynes pictures the stock market as a casino guided by animal spirit. He argues that investors are guided by short-run speculative motives. They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short-run price movements. What is your view on Keynes picture of the stock market? I think he is right. And it is really important to understand. But the problem is stock market will always work like it. As long as the markets functions in the same fashion there will be booms and busts, fear and greed and people will do the opposite of what they are supposed to do. But investors who understand history, past and logic would not be tempted to make the same mistake. In fact they would be able to profit from that. So I agree that stock markets act like a casino where people are looking for short-term fluctuations and not long-term value and it is there for their detriment. That is why we stress investor education, but if it is told to ten people only one person understands it. Globally investors behave the same way, when they come to the stock market they look at price and not value.

Do you think that as soon as some information regarding a security is disseminated in the market, it is reflected in the price? Do stock market participants fathom the information correctly and act rationally or there is a discrepancy? Beauty is in the eyes of the beholder, similarly market sometimes takes time to grasp the reality of particular information. So the immediate reaction is sometimes not correct but in a longer term it can have a huge impact on a stock price. Understanding the value of particular information and its implication on a company is an art, and not everybody can understand it atleast in the short-term. Yes information disseminates and there is immediate reaction but the final conclusion of that may sometimes take even years before the market understand what it holds. For example, in 1989 when Berlin wall fell and entire world changed. But the correct conclusion to that was the triumph of capitalism over communism and the icon of capitalism is free markets. So that time you would have seen a global bull run in the markets. And yes the Sensex for example went up 50 points and the Dow Jones Index went up 100 points, but over a period of time Dow went up from 1000 to 10000 points and that was when the ultimate effect of the triumph of capitalism was understood. So yes in the short run markets may have gone up 50-100 points but the full impact was seen and implemented till 1999. So definitely markets do not understand and fathom the information correctly, if markets would have been efficient I would not have been in business, I would have been a poor guy.

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How do you think should investors identify good investment opportunities? The first thing is you should always look at your circle of competency. The second thing is always you should always buy value, because even if you look at your circle of competency and buy expensive stocks, it will not generate returns. And so the trick to all investing is to buy assets when they are cheap. You should buy it when you think the company is worth a buck when it is selling in the market at 25 cents. Have patience. You only need compounded return of say 20% every year and that would work, that is what Warren Buffett has done and that is what makes him the second richest guy in just 40 years. If someone comes to you and say that buy this stock and it will generate 30% returns in three-months you dont want to believe him. Because the man who is richest in the world generated only 22.5% return every year, so the idea of someone giving you the tip of doubling your money in 2months is playing stupid and that is when you will fall flat. It may work once but it will not work always. Be stock specific you are not investing in the stock market you are investing in the business.

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2. I4 (Interviewee 4)
Are Indian stock markets efficient? India is a developing economy and for high growth markets like India, EMH does not hold true. In fact, efficient markets are only possible in an ideal world, but not in reality. Perhaps developed markets like US may be more efficient than Indian stock markets, but even those markets are not completely efficient. India is not as efficient as the developed markets because it is an emerging economy. Markets of countries like UK and USA are saturated, the growth rates of companies are stagnant. However, in India, every now and then there is some sector that suddenly grows at high rates and people who are able to identify them beforehand can outperform the market. In fact there are many Fund managers and investors who have consistently beaten by identifying such sectors before the whole market have got into it. Therefore, Indian markets are not as efficient as the developed markets.

What investment strategy do you think investors should follow? Active or passive? (considering the evidence that cost involved (both time and money) in pursuing an active management strategy outweighs the benefits and Money Managers are not able to beat the market) Why? Does the risk profile of an investor make a difference? What investment opportunity should be adopted by investors actually depends on their risk profile. If you are a more risk-averse individual, you should go for active investment strategy, while a risk-neutral or less risk-averse person should go for passive strategy. Even in active strategy, risk level of person will determine what funds he is putting his money in. A more risk loving person might put his money in say mid-cap fund while a risk-averse individual will prefer more conservative funds. I think that the risk profile of investors determines their choice of investment strategy. Risk is low in pursuing passive investment strategy. But mainly, in a country like India, they should go for active investment strategy because in a market like India abnormalities often occur which causes inefficiency and opportunities for active managers to profit from them. As I mentioned, mismatch in expectations also causes inefficiency and managers who are able to identify these mismatch can make returns greater than the market returns. For example real estate sector is hot today and there are many companies which are overvalued, but because of the overconfidence in the market, people are not able to match the intrinsic value and the market value of the sector.

Why are Institutional Investors not able to beat the market consistently despite all the efforts and costs they indulge in? Which types of stock (large-cap, mid-cap, small-cap) do you think Institutional Investors concentrate on? Why is that?

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Huge costs are associated with the research they conduct and that is why they are not able to outperform as you rightly mentioned that the costs incurred in their research and other expenses wipe-off the benefits. Not much idea.

Investing for the long term means judging the distant future, judging how history will be made, how society will change, how the world economy will change. Reaching decisions about such issues cannot proceed from analytical models alone; there has to be a major input of judgment that is essentially personal and intellectual in origin. Do you think this statement is correct? Are subjective issues important in evaluating investments? Yes this statement is correct. Some factors that may be true and applicable in one market may not be applicable in India, say certain behavioural factors application for US investors may not apply on Indian investors. The difference in culture and society, like how people perceive things, may be different and how would they act upon it will also be different. There always exists some difference of opinion amongst people for same thing. Difference in view and perspective exists like people may view the growth prospects of a company or a industry differently. Such mismatch in judgement and opinion creates opportunities to get returns more than the market. There is contrarian opinion that is why buyers and sellers exist at the same time. There may be situation in the stock market when there is a upper circuit or lower circuit, i.e. when there are no buyers or no sellers for a particular stock. But such situation is rare and does not prolong.

How important is Behavioral Finance in making investment decisions? Can you provide some examples of investor behavior (irrationality per se like herding behavior, over-pessimism or over-optimism) that causes inefficiency in the market from the Indian stock market perspective? Yes Behavioural finance is actually very important and understanding behaviour can actually help us in not making the errors people generally commit in the market. The example of irrational behaviour that I can think of in context to Indian markets is that people dont want to be left out when everyone is investing in the market or investing in a particular stock. And they do this even if they are not convinced to invest, it is out of the mentality that everyone is making money and I will be left-out, so without understanding also they take a bet in the market. Even though their instincts are against it. Certainly the explanations provided by the behavioural theories are correct, we see the herd mentality everywhere, over-optimism always exists when the markets are bullish and there is over-pessimism when the bear market is in phase.

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Appendices What is your view about the Keynes philosophy and why? As for the Keynes statement on stock market, I dont think it is completely true. Speculators do exist, but then there are people who want to stick to their decisions and are not speculating. That is why systematic investment plans are popular in Indian markets. People do take a longer term view. But like I said, traders also exist who carry out speculation. I would suggest that to find out the correct picture of ratio of speculators versus investors look at the statistics or delivery volumes in stock markets. Also, I think a data research and survey would be more appropriate to find the answer to this question, you can easily find this data.

Do you think that markets price the securities correctly: - in short-term? - in medium-term? Or - in long-term? Why? Market prices the securities in a longer period. Inefficiencies would go away in a longer-term and there are no surprises in long-term which would deviate the market price from the intrinsic value.

Do you believe in the existence of overvalued and undervalued stocks as against the many researchers and investors who think that there is no such thing in the market, and it is just a way of fooling investors? Yes overvalued and undervalued stocks do exist. In fact it is corollary of the fact that markets are inefficient. Expectations differ in the market, which results in undervaluation and sometimes overvaluation of the stocks.

How do you think should investors identify good investment opportunities? Individuals do not have access to information and it is not feasible for them to carry out the expenses for collection this information. It is therefore advisable that they should search for good money managers in the market and invest through professionals via the mutual fund channel.

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3. Mr. Ranjeet Hingorani

Do you agree with the EMH? To what extent do you think the theory holds true? Do you think that it is possible to beat the market? If yes then can you please explain how it is possible? Empirical evidences prove that passive investment strategy are better and more beneficial than active investment strategies, as the markets reach efficiency and the cost incurred in discovering the strategies to outperform the index outweighs the benefits received from them. Is this true? I do not agree with the efficient markets theory. Market is a reflection of so many people taking decision at the same time and they make those decisions on the basis of the information they hold, their interpretation of the information, out of some idea they hold, their psychology, etc., which differs from person to person and hence all these factors together makes the market inefficient. The decision they are making may be based on peoples fear or greed. Stock prices may not reflect the intrinsic value of the company because of the use of these factors in decision-making. However to some extent the markets are efficient, everyone has access to same information everyone reads the same reports, newspapers, evaluates EPS and other accountancy tools for analysis. So on the face of it youll find that the valuations are fair. But there is something going inside the company, which is intangible that no other person can see but you can see. That might be due to the nature of the business, you have edge over the others, or it might be because of your vision and analytical skills which others do not have. So to some extent the theory works, you cannot outperform the market with the help of the past information. But using the public information and the insight and through your skills, it is possible to beat the market. Skill plays an important role. Nature of the business, capability of management, quality of the management, such factors should be taken into account while selecting stocks for investment. In MF industry, Institutional imperative that we call it, everybody has to perform because there is a pressure from the unit holder that your fund is not performing, so they have to go for momentum stocks that are hot in the market, stocks on which there is lot of news going around in the market because the bonuses of the FM is also linked to the returns. So therefore they commit mistakes and are not even able to meet the index returns. They falter in between. But for individual investors like us there is no such pressure. We can take our own time, and we dont have a concept of sticking to say large-cap, mid-cap or small-cap stocks, we can find any company wherein we believe in and then can wait for that company for a long time to start giving us returns. We dont have that compulsion.

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Appendices There are 6000 companies listed on exchange and certainly all the analysts are not tracking all those companies. They are generally tracking the companies of the sectors which are hot, companies which are in the Index, they are over-researched. But certainly there are industries, sectors, which are dull. But it doesnt appeal to the institutional investors, because those companies dont give returns in shorter term. So they ignore such companies or sectors.

Do you think that Indian stock market is as efficient as the capital markets of other developed countries like US or UK? Why? Also there is no difference in the efficiency level of the stock markets in India and other developed markets because the people are the same, behaviour is the same, and the greed exists everywhere. They have also gone through the dot.com boom and bust like India and India is also now witnessing the real-estate boom.

What investment strategy do you think investors should follow? Active or passive? (considering the evidence that cost involved (both time and money) in pursuing an active management strategy outweighs the benefits and Money Managers are not able to beat the market) Why? Does the risk profile of an investor make a difference? Individuals investors who do not have expertise and understanding of analysing companies, markets and sectors can straight away go for indexing, because the expenses of later and cost to the investor is less. So he can go for index stocks or index funds and he will be much better off than many active investors. When market falls, active investors loose much significant amount than passive investors. Investors should have a much unrelated portfolio and reduce the risk of the portfolio. So for example I hold 4 stocks, those stocks should not be related to each other. Risk profile of an investor may not necessarily affect his choice of investment strategy. A person who is risk averse, because he has made one correct decision in investing his risk taking capacity increases as he becomes intelligent and brave in his own eyes. And then he takes that additional risk and that is disastrous. So risk profile for me is a relative term. When an investor is making money, for him risk becomes irrelevant and once he loses money he realises what he has done and becomes riskaverse but then it is too late.

Institutional Investors: - Many researchers have proven that nearly all mutual funds and other institutional investors fail to beat the market on a consistent basis and that they underperform the market. In most of the instances, when they actually are able to beat the market, the costs incurred in their research and other expenses wipe-off the benefits.

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Appendices Can you explain the reasons for this? Or provide evidence when a fund or a company has been able to outperform the market over a consistent basis? Which types of stock (large-cap, mid-cap, small-cap) do you think Institutional Investors concentrate on? Why is that? They are on interest, their bonuses are linked to their performance and so they start taking higher risk without understanding returns will come or not. And another thing is that they are only comfortable with buying large cap stocks thats why they are over-researched. I think they do this because if they dont get good returns they can say that they bought a good company. So rather than venturing into something that is unknown or less popular, they pile on large-cap stocks, and they dont want to take that risk. So their returns are ultimately market returns as they concentrate on Index stocks.

Do you think this happens because of other factors also, say liquidity. Small and mid-cap stocks do not have liquidity and these managers cannot easily exit when they want. See, liquidity is again a function of demand and supply. Now if I buy a good company and eventually its stock price increases, its market capitalisation will also increase and the same market cap comes into buying criteria. So finally that is the question of belief. So maybe today the liquidity is not so high but if you think that this is a good company and in few years it will grow and give good returns then automatically the liquidity will come in that stock because of increase in the marketcap. Institutional investors generally concentrate on large cap stocks.

Investing for the long term means judging the distant future, judging how history will be made, how society will change, how the world economy will change. Reaching decisions about such issues cannot proceed from analytical models alone; there has to be a major input of judgment that is essentially personal and intellectual in origin. Do you think this statement is correct? Are subjective issues important in evaluating investments? Stock market is a game of probability, i.e. how good you are at projecting the future. And that projection doesnt come so easily. You have to be sure about what are venturing in to and that comes with thorough research and analysis. That requires a lot of skill and it doesnt come overnight, it comes with a lot of experience and understanding of the market and businesses. Essentially you need that intellectual, foresight and judgement to decide whether to be there with the company for 5 years and make money. Once the opportunity is lost, those 5 years will not come back and also you have many companies to choose from. So that judgement is required and that is matter of skill, which everyone does not possess. There also lies the allocation of capital concept, which is the most difficult

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Appendices part to me, i.e. I should be able to decide how much capital I should allocate to a particular company, can I allocate a percentage of my capital to that company for 5 years without making much difference to my portfolio. I certainly agree that you should be confident and very sure about your decision and there lies the concept of Warren Buffetts circle of competency that says you should know and understand what you are doing and investing into. I agree that that judgement is relative and you might go wrong but then again there comes the skill into picture. Through understanding of the business you are sure that this business is going to quadruple in next 4 years, although this surety is again relative. But that is what the skill is all about that you are different from others. There is again a philosophy into investing, that I am not going to buy business which can loose money and exit from the market. So I have to be sure that the business I am getting into never loses money. Temporary setbacks are possible, but there is an Economic goodwill of that business that can again generate that kind of money in short period of time. I am ready to say no to 99% of business which this philosophy says that have the chance to loose money, though you know they are going to do well right now. Like Bank, a good bank, whose management doesnt do bad loans and it is careful about the cost. The banks services are always desired, everyone needs a bank account and the bank is nimble enough to come out with fantastic products. Another example is of a company in the paint industry, Asian paints, the company is there since last 40 years and it has been market leader, it is number 10 in the world. The company has not lost money. Paint is always needed and desired and now the margins are improving, the company has pricing power in the industry and they are coming with higher-end products where margins are huge. Also, what I am trying to say is that people might have identified such companies, but these companies dont get overvalued. Their intrinsic value and market value go together; such companies dont fluctuate too much in their market value. There is not much volatility in their prices. They have stable growth and because of this stability most of the people stay away because there is not much short-term movement in the price. But over a long run, these companies generate returns higher than the market. The management of such companies dont want speculators to come in their shareholding and make their prices volatile. So they deliberately keep the prices stable. And there is so much greed in the market that people are not interested in such stocks because they dont have much short-term movement. So today by investing-in in such companies I might not be able to beat the market, but when the market will fall, my companies will not loose their value in the market or very nominal decline. Identifying such companies is the key to investment decisionmaking.

How important is Behavioral Finance in making investment decisions? Can you provide some examples of investor behavior (irrationality per se like herding behavior, over-pessimism or over-optimism) that causes inefficiency in

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Appendices the market from the Indian stock market perspective? And its Cause and effects? Behavioural finance is very important while making investment decision. Everyone is investing in the market and making money then why should I be left-out. So without knowing ABC of investing or the company, people also start investing because everyone else is doing it. There is a tip-behaviour in the market, because no one wants to do the hard-work and still want to make money.

What is the role of discipline in stock markets? Discipline is also the most important part in making investment decisions. You have to be disciplined while making investment in the stock market; you should not get carried away by the market. You have to know your limitations and work on those limitations. You should get things done in simple ways. Most of the people try to complicate things and then solve it and then get things done.

Do you think that markets price the securities correctly: - in short-term? - in medium-term? Or - in long-term? The market prices the security correctly only in the longer-run, in short-term it is only a voting mechanism

Do you think that as soon as some information regarding a security is disseminated in the market, it is reflected in the price? Do stock market participants fathom the information correctly and act rationally or there is a discrepancy? The expectations sometimes of the market or company are so high that people actually misprice the securities, that is what I would call as overreaction bias and as a result no one gets any returns. People overreact to the good news and pay higher price for the securities. So finally it will average out somewhere down the line. So higher expectations exist in the bull market and people are overoptimistic, without understanding that there are other factors which will de-accelerate the growth. On the basis of just one piece of information people under-react or overreact and ignore the other factors that may be equally important in price determination. Bottom-line is, you need skill to identify good investment opportunities, which comes through experience and also you should always select good businesses.

Do you believe in the existence of overvalued and undervalued stocks as against the many researchers and investors who think that there is no such thing in the market, and it is just a way of fooling investors?

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Appendices Yes, overvalued and undervalued stocks do exist in the market.

How do you think should investors identify good investment opportunities? For investment opportunities, investors should look for such companies, whose products are desired and will always be needed in the market, which have market leadership and edge over others in the market, who make constant innovations, where there are not much of government regulations. For e.g. the paint industry in India, the product is desired and it has no alternative, in that sector there are companies which have sort of monopoly, they have pricing power and margins are huge. But that sector has not been paid attention by institutional investors. You will have to read a lot, go through annual reports, find out companies which have consistently made profits and will be able to do so by looking how their management is, finding out what are their plans for the next 10 years. You need to envisage whether this business is going to be there in the next 10 years, what will future hold for this company. From these aspects you have to refine your research and select stocks of good companies. You have to get into the nitty-gritty of the balance sheet of past few years, understand the company and the sector it is in, understand its competitive position in the market, how good the product or service it is selling is, how good its research and development department is. And then finally you have to make the judgement whether the company is good or not and its product will remain in the market in the coming 10 years. Also, you should only get into the industry or business which you understand. And there comes your circle of competency, you should be able to understand everything about the company or business you are intending to invest in. Moreover, you should not be guided by short-term motives. There is no short-cut in life and you have to be patient to be able to consistently beat the market. You can create wealth only through long-term wealth.

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4. I5 (Interviewee 5)
What is your view on EMH? Firstly about EMH, in theory it holds true, yes. But frankly in terms of practicality, its efficient over a longer period of time but in shorter term say 3-6 months over even a year sometimes market may not be efficient. Do you think markets price the securities correctly? Over a longer period yes.

Is it possible to beat the market consistently? It is possible, over a longer period of time, to consistently beat the market. At times you might underperform maybe for a quarter or two, but then by and large it is possible in India to outperform the market consistently, mainly through specific stock selection and sector selection. At given points in time you will find certain sectors doing exceptionally well so if your weightage in those sectors is good, higher than the index weightage, then you can outperform the market. And that is not difficult in a country like India, to find 2-3 stocks from a longer perspective, which will do better than the market. And a lot of funds actually have beaten the market consistently over the past several years. India is a volatile market, it is not a very stable market and often times what happens is like there is not proper dissemination of information, it takes time for the market to understand that information. The no. of participants is not completely broad based, of course now things are changing as India is getting integrated with the other global markets. But I think Indian markets will still take time to reach the level of developed markets like US or UK market. Indian stock markets are not as efficient as the markets of developed economies. In volatile markets like India, passive investment strategy will not work, will not generate good returns. But if in 2003 you would have expected the Index to go to 13000 from a level of 4000 in 2-3 years time, then passive investment strategy would have been awesome, and you would have made much more money than through active strategy. But having said that, because you dont know whats going to happen in say next 6-months or further ahead, whether the markets will go up or down, its always better to pursue the active management strategy. Identifying the fundamental factors of a sector in terms of turnaround of the sector, the valuation of the sector, i.e. is it undervalued or overvalued, the growth prospects of the sector and other such factors is the starting point for investors to identify good investment opportunities. Now obviously if a company is within that sector, say for example sector like cement now when you know that infrastructure of the company is

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Appendices improving and a lot of investments going-in in infrastructure. Obviously there is going to be demand for cement and you should try to gauge the demand supply equation in that sector and identify if the supply is more than demand or vice-versa because that will be the determinant of the actual price of the cement in the market. So these are kind of ideas that you can get, and if you keep monitoring these through reading, meeting management, meeting industry associations then you can identify good investment opportunities and its not very difficult.

So many researchers and analysts exist in the market, that they might have identified the sectors or companies that are doing well now or those which have a good outlook for the future. So it is not possible to outperform the market as the price already reflects all available information When you start off, thats the reason it is important to be ahead on the curve. After some time everybody will be starting to talk about it and thats when you see the performance of that sector tends to be muted despite all the fundamentals still holding true. At this point in time a lot of smart money gets out of that sector and then looks for something else. Timing is therefore extremely important in making entry to and exit from the market. Many people say that we dont time the market its not possible to time the market. But in my view, it is difficult you got to get it right. Otherwise what is the point in identifying something which everyone has got into. You got to get in early and be at the lead rather than a laggard because then you will only make index returns and not extraordinary returns. The idea is not only to get the sector right, but to get it at the right time because it is not easy to determine the turnaround.

Shruti: You should be first-mover in the market? Yes.

Empirical evidences prove that passive investment strategy are better and more beneficial than active investment strategies, as the markets reach efficiency and the cost incurred in discovering the strategies to outperform the index outweighs the benefits received from them. Is this true? You are right in a way that majority of the people are not able to beat the market and the reason is precisely this that they do not get in early in the market. You need to be early and everybody cant be early. Today the market is very-well researched, there is a huge amount of tracking going on the media is all over the place so finding those opportunities are getting difficult by the day. 2-3 years ago it was easy in India to identify such opportunities, but things are getting difficult in the sense that you pick up any mutual fund review and you will find most of the people are invested in similar sectors or stocks by and large and there

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Appendices is hardly any differentiation. And I am admitting that it is not easy but the fact is it is not impossible either. It is not possible to beat the market consistently. Today you might outperform but cannot guarantee for tomorrow. Is it correct? It is quite possible The way industry is getting so much attention and so many people are involved in tracking that, managements are coming out and talking about their performance, a lot of information is getting disseminated on websites and through news so really I mean that differentiating factor is really diminishing. And maybe in the next 5 years even Indian markets will be like other developed markets in terms of efficiency level. Wherein beating the index will be a real challenge.

You do you think at the bottom of the day it is not skill that will play role but luck. The skill is there but then so many people have it It is skill in a way because everything is not company researched, everything is not company fundamentals, a lot of it is got to do with the flows in the market, what is happening internationally and lot of other factors, also how successful the person is in terms of managing the money. How quickly and what your access to that channel is that will determine whether you having cutting edge over others. Apart from the quantitative aspects of the companies there are many other factors like government policies, price of crude, commodities, how is the global interest rates cycle, etc. which determines how the company or the market will perform. In fact interest rate is one of the most important determinants in terms of flows into the emerging markets, which greatly affects the whole economy. For example if the interest rates are rising, then obviously the money will not flow into equity and it will go out from the emerging markets (India) to more developed markets. So interest rates is very important in determining in which phase the market will go because flows from FIIs affects the emerging stock markets to a great extent.

What investment strategy do you think investors should follow? Active or passive? Why? What factors do you think should be taken into account? Does the risk profile of an investor make a difference? In a country like India where people look at the Index on a daily basis, and you might find a client who says that I am risk averse and I am happy with a 10-15% return so you might structure a portfolio which is relatively safe for him. The index would give a 20% return but you structured the portfolio such that the returns generated were 15%, the client might come back to you after 6 months and say that look buddy the index has given 25% return and you have given me a 15% return then why should I pay you anything. So people dont understand that risk, atleast in India, that high

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Appendices returns come with high risk. And that is why in India the MFs are not allowed to promise any particular return in equity markets. Do you think investors in India are not very well-educated in comparison to investors of developed markets? That would be a fair statement to some extent, which is why the regulator encourages everyone to go into the equity markets through MF, because they do not understand themselves their risk profile, what is diversification. Emerging markets are generally volatile.

In context of Institutional Investors: Many researchers have proven that nearly all mutual funds and other institutional investors fail to beat the market on a consistent basis and that they underperform the market. In most of the instances, when they actually are able to beat the market, the costs incurred in their research and other expenses wipeoff the benefits. Can you explain the reasons for this? Or provide evidence when a fund or a company has been able to outperform the market over a consistent basis? Which types of stock (large-cap, mid-cap, small-cap) do you think Institutional Investors concentrate on? Why is that? There is herd mentality on the streets. Suddenly when you see something doing well, everyone wants to pile on it. That is why you got to be early in the game. When you missed first 20-25% of the rally then you should not get into it, because then the whole world has got into it and the smart money has actually gone out. That is the fact, most MFs do not beat the market, but there are some MF that have consistently beaten the market, E.g. of a newspaper article. It all depends on a mandate, if it is a diversified fund, 80-85% of the stocks would be mid-cap, if it is a mid-cap fund obviously it will be a mid-cap focus. But if there is a flexibility then most people will focus on the large-caps given the facts that liquidity is important from fund management perspective. What happened in the mid-June (2006), when the markets fell, mid-caps plummeted 40-50% when the large caps were down 20%. There is a bit of comfort and much more transparency in the large-caps. The comfort-level in investing in large-caps is much higher than the mid-caps so generally people tend to stick to large-caps.

Does such behaviour causes undervaluation of mid and small-cap stocks and therefore inefficiency in the market? It does, it certainly does, which is why large-caps are always traded at a premium compared to mid-cap stock.

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Appendices Liquidity is one of the main reasons why this happens. Also, large-caps are generally well-researched, well-covered. There are a lot of fund managers sitting abroad and for them it is easier to get information on large companies that will not be necessarily true for some of the mid-cap companies. Comfort level for large-cap is certainly higher.

Do you think that if someone takes that risk and identify good opportunities in mid and small-cap segment then he can outperform the market? I wouldnt go that far. Over a period of time market recognises all of this. And if there is some gap between mid-cap and small-cap stocks then it becomes apparent. For example a month and a half ago (September 2006), it became quite evident that mid-cap stocks were not moving and a lot of momentum was going on in large-cap stocks. And typically after a sometime large cap need a particular rally or a decline and when large-caps tend to become overvalued, then at that point in time people take their money out of large-cap and invest it in relatively liquid mid-caps. And those companies start going up in terms of share prices and that segment start picking up until it is overvalued and the shift occurs back towards large-cap stocks. And thats the cycle and its a very typical pattern. You may term it inefficiency. But it is a known inefficiency in the market. It is not that people dont know about it, everyone knows about it. When the rally is starting it is better to be in the large-cap stocks because if you are wrong it is easy to get out of the large-cap stocks. But if you are wrong and you select mid-cap and if the markets start to go down then you might have difficult in exiting, thats precisely the reason. The cost of getting-in in the small-cap stocks is high, difficult is in the entry and exit cost because of the illiquid nature of the stock.

Behavioural Finance It is fairly imp because a lot of time what happens is that there is generally consensus in the market and the consensus normally is wrong. When the whole world becomes pessimistic, when there is a herd mentality, generally it is time to go reverse. It is not easy to kind of anticipate and determine but it is important. People dont want to invest money but play with the market. In 2000, everybody was in the equity markets and everyone was buying technology stocks. Even the diversified Mutual Funds had 30-40% exposure in technology stocks, i.e. diversified funds we are talking about. This was because of the performance, the technology sector was performing so well that they increased their exposure in it. May be that initially they held 10-15% position in tech stocks but that

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Appendices must have grown to 30% because the other sectors was going down. There was so much concentration on tech sector. People were justifying stocks trading at P/E multiples of 100 and 80, people were looking at 10 years story of technology companies performance in India. I mean it is still true, its not that the tech story has completely gone from India, it is still a great sector. But what had happened was that the entire ten year story was priced in a period of 6 months time of timeframe that was the problem. Talk about the reverse, in 2002-2003 when the markets reversed you could buy the technology stocks at 10-20% of their values in 2000. Even in down-cycle none of the technology companies in India were making losses, but despite that people were not buying the companies that earlier they were ready to buy at 80 P/E. I am talking about large-cap companies. So thats the other extreme, people dont want to get in the stock market.

Can you outline some other irrationality of investors apart from what you just mentioned? Over speculation, chasing stocks with no fundamentals at all just because someone on the street or your stock-broker has recommended you. Many people do that, even after burning their hands many a times they still do that and end up buying things because someone else has recommended you. People dont have time to analyse and get the information on the stock, because they have their own work and business to manage, so they just buy whatever is recommended to them. But the attractiveness of the stock market is so overbearing that they cant afford to miss anything like that. And mind you losing an opportunity hurts you more than having actually lost money (42:40). Suppose I have bought some shares and I told you to buy and you happen to miss that opportunity and I made a profit from it then youll feel so bad having missed it. On the other hand if I bought something and lost money and you bought something and lost money, you would not feel so bad because I have lost money too. So that is the human nature and this sort of behaviour is often seen amongst Indian investors. Seeing that your neighbour is making money and you are left out hurts more than when you actually loose money in the market. This is why there is so much tendency of over-speculating that you go beyond your mean. Typically when the markets are plummeting and are at their bottoms, you play within your mean because you are scared of losing money. So your size of investment at that point of time is also very low, say you invested only Rs. 100. But as the market goes up and as you make money, you increase your Rs100 investment to Rs1000 and 1000 climbs to Rs5000 and 10,000 and 15,000.

So what you mean is that the risk taking capacity of people increases as they make money? Its not the risk capacity; they very well know that if this Rs15000 halves or even goes down 30%, it will wipe out everything they have. Because you have gradually

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Appendices built it up in lots and your Rs 100 investment has actually climbed to the multiples of that. It is therefore the psychology. Nobody thinks of their capacity. In fact it should be the other way round, but quite frankly it never happens. This kind of behaviour is actually driven by the greed. Greed is therefore one of the irrational behaviour that investors succumb to which affects their returns in the markets.

Keynes pictures the stock market as a casino guided by animal spirit. He argues that investors are guided by short-run speculative motives. They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short-run price movements. What is your view about the Keynes philosophy and why? I think it is a fair comment and I dont dispute that. Very few people in the Indian markets are there for a long-run. Out of 40 years in the stock markets in USA (the numbers and details is given in Peter Lynchs book), the annualised returns are better in the stock markets than in bank deposits and fixed income market. But out of those 40 years, the profits were actually made in 4-5 years, the real money that is. And that is the reason for this kind of behaviour as described by Keynes. Nobody wants to wait for 40 years, for that matter no one wants to wait for 5 years. They will rather put money in stocks or funds where theyll get say 20% returns in 6 months or 1 year. It is a fact and it is not going to change as long as the markets exist.

Does this behaviour exist even in developed economies? Yes, this behaviour exists even in the developed economies, no question about that.

Do you think that markets price the securities correctly: - in short-term? - in medium-term? or - in long-term? Why? Medium-long term. In short-term there might be fluctuations, there might be discrepancies in terms of pricing but in a long-run definitely markets prices the securities correctly. Reason being that the information might not have been incorporated completely; there might be disbelief in terms of what is going on. There may be other external or international factors (psychological) like if there is a war going on somewhere and their markets and other markets are not doing well, people might expect companies and markets in India to do well. There are so many things influencing your mind

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Appendices when you are buying or selling that in short-term there is discrepancy in pricing but in longer run it is corrected because the information sort of populates down (people understand the information and what lies behind it), other factors also settle down and this particular factor gains priority and people understand their former mistake. In short-term reactions occur. There is immediate reaction to say earnings expectations, and the moment the expectations doesnt match, the stock prices crashes or rises depending on what was the expectation and what was declared. However in long-run people find out there are analysts meet, questions asked from companys management, they confirm whether this is a one-off thing, find out the reason for the numbers declared and depending on that assessment the stock price will correct.

Do you believe in the existence of overvalued and undervalued stocks as against the many researchers and investors who think that there is no such thing in the market, and it is just a way of fooling investors? Yes overvalued and undervalued stocks exist all the time

How do you think should investors identify good investment opportunities? Let us talk about undervalued stocks. There could be undervalued stocks because: - There is not much of coverage in that sector or company, - No one is looking at it - It is in a sector which everyone hates, no one likes that particular sector So the whole idea is to find out why is this company standing out, why has the market not recognized it. There is a reason and it is not that it can remain undervalued for a very long time because the market remains inefficient only for a very short time. The moment the management gives some indication markets starts to price that in. When you are scanning the universe, a lot of time you will find undervalued stocks. For e.g. in 2004 everyone knew that the market is undervalued, but no one had the courage to put-in in equity having seen what happened in 2000. They were all waiting for companies to start performing well. Even in bullish markets you will find companies which are undervalued because they are ignored by the analysts. The best way is to do it yourself; in this market you are all alone. It is a lot of hard work, you need to study about the company and the industry it is in.

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Appendices But how does an individual identify the company or the industry? There are different approaches for it. You can either go for a top-down kind of approach wherein you look at the macro scenario and narrow your selection Or you look at within the sectors that are doing well. There are lot of databases available and you can find out that in a particular sector the 3 companies are going extremely well n stock market and there are 2 companies which are actually languishing, nobody wants to touch them. So start from there. You should do a lot of reading and you can identify sectors and company from there. Suppose there is a new technology coming-in that you have heard about, and a particular company is getting into it maybe through designing, engineering or anything. Then your due diligence starts and you identify the growth opportunities of this company, you might be ahead of the market, but you should be patient. But look for growth prospects of the company and profits that is the only tool you have to see if the company will do well. Market likes growth and it is willing to pay premium for that growth. Never look at past and base your judgment because it is history. The future is completely different. The company might have changed its technology, changed the way it does business, it might have moved to international shores, it might be tapping new markets, might be acquiring some company. A lot of things would have changed. Lot of qualitative factors would have come in. So the point is, P/E would not determine the outlook, you got to adjust that P/E to growth, the expected growth. Through PEG. That puts things into perspective. Even today India is one of the most expensive markets in this region in terms of P/E multiples. That is the general perception internationally. The fact of the matter is Indian earnings are growing @ 25% p.a. So if they are trading at 16-20 times it might be justifiable. There would be other markets trading at 12 P/E multiples, but their corporate earnings growth is 510%. So would you go and buy that? So if you adjust the P/E ratio to growth and look at PEG instead of P/E you might find an answer there for identifying good investment opportunities.

Do you believe in technical analysis? Not from stock selection perspective but from stock entry and exit point of view. It does help you in selecting your entry and exit points. So I wouldnt ignore it completely. You cant go and select stocks on the basis of technical analysis. But having selected a particular company, you should go back and look at the charts and you can check if there is volume happening in that stock, is there some accumulation going on and such factors, what are the range in which you can typically buy and if breaks a particular level then you need to be a little careful. So you can go back and check your fundamentals, if it still holds or not. So it is a good guiding tool but not from stock selection perspective.

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5. I6 (Interviewee 6)
Efficient capital markets theory assumes that two people think alike. It is good in theory but in practise it does not hold true. In real world information is analysed by people, who interpret it differently. Had the analysis been carried out by computers, the theory might have been true. But every individual has brain and using his/her brain each one interprets or views things differently. The mere presence of brain in humans deviates markets from efficiency level as a market comprises of people and people make the markets. Efficient market theory is helpful in understanding markets and it can serve as a benchmark from where to start, but if we will think that markets are going to completely efficient then markets will cease to exist. EMH is correct in theory but if it will be implemented in real life then no market will exist. There are cycles in the market. Let us say for example, there are two vegetable vendors and you decide to purchase vegetable from one of them because he is selling cheaper than the other. Now, you think that he is selling cheap and he thinks he is making a profit and so the deal takes place and you buy from him everyday. Now a behavioural part will come in this deal and that vendor will start thinking that ;oh this lady buys from me everyday and I think I am selling too cheap and so he starts to increase the price of his vegetables. You will realise that this vendor is now cheating and you decide to try someone else. And so a cycle forms. And this cycle brings things to the equilibrium. So sometimes there are excesses in the market which brings things to the equilibrium. And anything that becomes excessive starts devaluing something. Take an example of your personal life, if you devote too much time and energy on academics, then you will start ignoring your health, your extra-curricular activities and you might even start devoting less time to your family. But you are expected to balance-out everything and this balance is nothing but bringing equilibrium to your life. Innovations keep happening, this how this world grows. Excess keep happening, people overvalue or overestimate the power of new innovations. That is what happened in 1929 about the steel, people overestimated its potential and there was overcapacity of steel and the World War happened. Similarly when the semiconductor chips came in people overestimated its potential too, there were books in that era written that in 5 years all the work will be done by Robots, domestic, etc. And it was overvalued. But that is not the case, we dont have robots doing our household work.

Empirical evidences prove that passive investment strategy are better and more beneficial than active investment strategies because as the markets reach efficiency the cost incurred (time and money) in discovering the strategies to outperform the index outweighs the benefits received from them.

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Appendices Is this true? A passive manager says that markets are going to go and down and up and down then why should I waste my efforts in predicting these ups and downs. Let me be in this market and invest in Index, so I will get the average and I am happy with the average, it is fantastic. But an Active manager thinks that because God has given me brains so I should use it. Because people behave differently and there is excessive for somebody then I will have the opportunity to make money out of this excessive by taking a reverse position from what others are doing.

Why are fund managers not able to outperform consistently? (Irrational behaviour also highlighted) Active managers are not able to perform consistently because they try to be jack of all trades, but they cant be an expert of everything. They got to understand this and only focus on companies and stocks which they understand, whose business, markets, products, management they can understand. An example for this can be given of Warren Buffett, he is an activist, in 2000 he made a statement that I dont understand IT industry and therefore I dont invest in it. For a brief period his performance was down as compared to other active managers who invested in IT companies. But his performance again soared and the other managers actually lost tremendous amount of money. In those brief periods of excess, one has to be focused on his basics and only concentrate on what he understands rather than getting driven or tempted by others. We as human beings consider ourselves as super efficient, we think that we know more than anyone else and that is where problem arises and that is why we underperform. If we actually contain to stick to our basics then only we will be able to beat the market through our skill through our vision. But it is easier said than done. Very few money managers, fund managers and other investors actually follow what Warren Buffett said. I dont understand IT, so I wont invest in it, Very simple. I will only invest my money in what I understand. Because if you continue to put your money in what you know better, you will do better than the others. Investors create pressure on fund managers and that is why they get into momentum stocks. When they generally evaluate the FMs performance they look at 3-6 months or a year record and then pick up the fund. Moreover, if the fund manager is not investing in the hot sector because his logic and judgement says not to and he underperforms compared to others, people will think oh he has lost his touch and they withdraw money from his fund and invest in other funds. That FM might then think that my business is suffering, if I dont invest in the hot sector I will be losing customers and I will be losing money. So let me also participate in the sector. When this bubble will burst I will walk out. But no one knows when this bubble will burst otherwise no one will invest in the bubble. So fund managers are making these mistakes because investors are forcing them to make this mistake.

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Appendices Investors put pressure on FMs to perform every quarter and the FM actually comes under pressure to retain the market share and they start looking at everything and basically become jack of all trades and master of none. And in the process they become average people and an average person will give you average returns. So they need to focus on their strengths. This is the biggest problem in MF industry. Another irrational behaviour on part of FM is that if they start to outperform market and make profits, they start thinking that they drive the markets. But they dont understand that they are part of the market and they cannot drive the market. A smart investor will never drive the market. He will actually take opportunistic advantage of the market. That is why he is a smart investor. It is all human nature. Glamour is also coming in this industry. They come on television channel and give advice on which sectors to invest in, which company to invest in. Today they recommend something and tomorrow that stock will move up. This is all glamour and they become overconfident about their performance. Also, there has to be equilibrium, so if I am making more money, someone will have to loose it. So I got to be smarter than others to make money. People have actually lost focus on their strength, the problem doesnt lie in the theory be it behavioural finance or be it value investing, problem lies with the implementation. You will see people all over the world investing in India. How can you know about India sitting in United States when you hardly visit India? What is on the Internet, newspapers, magazines and TV will not give the complete picture of India. You got to live here to understand the complete scenario economic, social and other. Everyone says India is a big story. But if India is a big story why are farmers in India committing suicides? This is something which they cannot monitor from United States. The point is, the problem is not with the theory, the problem is the way that theory is implemented. Just because the implementation is wrong, theory cannot be wrong. So active managers can make money and beat the market because there are cycles and there is nothing in this world, I stress, there is nothing in this world that is not cyclical. And if there are cycles you will always make money if you predict the cycles. However, no human being can predict all the cycles right at the right time. But problem lies, everyone tries to predict all the cycles. So you need to focus on few cycles in order to get returns higher than the average. Those who did it they are successful and we have examples of such people. However, not everyone can continue to outperform the benchmarks all the time like Warren Buffett underperformed for the brief period of technology boom. But then over a longer run, it is possible to beat the market consistently.

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Appendices Is there a difference in developed markets and emerging markets in terms of the irrational behaviour outlined above? The human psychology remains the same everywhere. And today the world is integrated. Therefore the nature remains the same, the mistakes remain the same, only the impact of the mistake has a different intensity. Once probably reason for this is that Emerging economies have are smaller markets compared to the developed economies. Other reason why the impact is severe is because the volatility is quite high, the liquidity is low but in developed economies the impact of such behaviour is less severe. Otherwise both the markets are similar.

Is technical analysis helpful in making investment decisions? I think it is a very good tool but only for the people who understand it. Equipments of a brain surgeon will only be useful in his hands, if a heart surgeon will use it, it will result in a fiasco. Technical analysis is helpful because it predicts the behavioural patterns of the investors. If people have behaved in a manner in past it is very likely they will do it in the future because humans have the tendency to repeat their mistakes or behave in a similar fashion.

Can you provide some examples of investor behavior (irrationality per se like herding behavior, over-pessimism or over-optimism) that causes inefficiency in the market from the Indian stock market perspective? The manner in which the money is invested is wrong. People are investing money in stock markets to generate short-term returns. But they will have to take long-term calls. And I think this phenomenon is worldwide, however it is more prominent in emerging economies like India and less in developed economies. If in the short run a fund does not perform, investors withdraw their money from it and invest in other funds and so FMs are also pressurized to select sectors and stocks which will generate short-term returns and so they fail to show their performance. People will have to take a long-term perspective in stock markets.

What is your view on the Keynes pricture of stock market? Keynes picture of the market is absolutely correct, bulk of the investments that is done in the market is done with the mind set of making short term profits and that is why people dont make money. People actually think it is a casino where cheap money can be made but believe me there is no cheap money in this world. Do you think that markets price the securities correctly: - in short-term?, - in medium-term? Or - in long-term?

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Appendices Over longer-term markets prices the securities correctly.

How do you think should investors identify good investment opportunities? An individual should never invest on his own. Fund managers exist for that purpose. But if you invest through passive managers, then you will only get average returns. Invest through active managers and for funds which are for long-run investment. Check the track record of the manager who is managing that fund and check not just 1-2 year track record but a longer record. You should have a business owner perspective when you are deciding to buy the stocks of a company. You should never invest in a company with the intention to sell it tomorrow if you want good returns in the market. Always buy stock with the mindset of owning that particular business then only can you make money from that investment. When you invest you should always evaluate the company in the sense that is it sustainable for a longer period and can it sustain the same growth level of its cash flow to generate returns for you. Always buy a business which in your mind is sustainable. You need to continue to focus on your strength and identify your strength. Likewise you will find 4-5 areas or industries which you understand. You should then predict the cycle of that industry, how is the future of the industry and the growth in it. Pick a company and see where it stands in that cycle. Then you meet the management and understand what their vision is, and their management style is. Evaluate the company using the Porters five factor model and then come to conclusion whether you should own it or not and accordingly make your decision.

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6. I7 (Interviewee 7)
What is your view on EMH, is the theory valid in Indian stock markets? EMH does not picture the true world. In real world there are many factors like irrational behaviour of people, unavailability of some information that affects valuation of the company, misunderstanding, etc. that contains the markets from becoming efficient. In India also stock markets are not completely efficient, though they are efficient to some extent. Mature markets of US and UK may be more efficient than India, but even they are not completely efficient.

What is the role of Behavioral Finance in making investment decisions? Can you outline some examples of irrationalities on part of investors in the market? Behavioral Finance provides a platform to learn from peoples mistakes, to modify and improve their overall investment strategies and actually profit from identifying these mistakes. It is indeed very helpful in investment decisions. Putting-in money on tips, overconfidence, and getting emotionally attached to the shares are all examples of irrational behavior seen in Indian markets. People are driven by greed, when they see prices of stocks climbing, without understanding the valuations they purchase those stocks and when it busts they all curse the stock markets. People show problems of self-control, and know that they may be unable to control themselves in the future. Investors get optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic amid downturns.

Keynes pictures the stock market as a casino guided by animal spirit. He argues that investors are guided by short-run speculative motives. They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short-run price movements. What is your view on this statement? Keynes made a fairly correct statement. In fact, this problem is more severe in Indian markets, everyone is here to make cheap money. Especially when the markets are on a bull run, you will find housewives, doctors, software professionals, bank clerks, credit managers investing in the stock market. In fact even my cook wanted me to recommend him stocks to put his money in. And believe me they dont understand a bit about the company they are putting their money in. It is actually like a casino for them. However, actual investors do exist, though sometimes even they are driven by this animal spirit.

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Do you think that markets price the securities correctly: - in short-term? - in medium-term? or - in long-term? Why? In short-term prices often deviates from their intrinsic value as it takes time for people to understand what lies behind the information. People also generally tend to forget the past and other factors that have an effect on the company and give so much weight to the current information that it leads the price deviation from its intrinsic value. However over a long-run the true picture is identified and hence markets price the security correctly.

Do you believe in the existence of overvalued and undervalued stocks as against the many researchers and investors who think that there is no such thing in the market, and it is just a way of fooling investors? Markets are often driven by greed and fear of the people, which causes stock prices to move beyond their intrinsic value causing overvaluation of stocks, as has been seen in 2000-2001 Internet bubble. Similarly when people suffer losses because of the mistakes they commit of buying stocks when market is highly overpriced without understanding fundamentals, they are so scared of the market that it causes companies selling sometimes below their cash value. In 2002-2004, I have actually seen that the offices which used to be packed with traders and investors 2-3 years back had no one except the operators. Stock brokers actually used to telephone their clients and convince them to come to the market atleast for a few hours. Being an analyst, I myself found some very good companies during that phase whose stocks were selling in the markets at unbelievably low prices and no one wanted to buy them. While 3 years back, people actually were paying 50x the price to get the same company. Nothing went wrong with the company, it was still selling its products, generating profits and running its business. But it was the fear and over-pessimism that was guiding them. This is a clear indication of existence of overvalued and undervalued stocks.

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7. I8 ((Interviewee 8)
Indian markets are not efficient and certainly not as efficient as developed markets of US and UK. Fundamental research gives returns better than the market. Capability and credibility of a company plays an important role in generating returns. Although I agree that majority of the mutual funds are not able to beat the market, but then everyone cannot be a winner. Explanation of why fund managers are not able to beat the market: - Varied schemes for varied objectives - Fund managers have to report day-to-day Net Asset Value (NAV). - above causes pressure on fund managers Because of the pressure, so many FMs just play the momentum. So in the bullish markets they outperform but in the bearish market they do not. In order to solve this problem, fund managers need to be disciplined and they should not hold very risky portfolio because everyone else is doing so, out of short-term motives of getting high returns. It is the ability that will always keep you ahead of the market. And you need to have a disciplined approach of investing. This discipline means not getting carried away by the market, resisting the temptation of generating high-returns in short-term, which is an important cause of all the FMs to underperform. Not following the herd mentality Just because everyone is doing it I should also follow the herd. They should only be venturing into industries and stocks which they understand. It is difficult to beat the market on a consistent basis, nevertheless it is not impossible. Intellectual capital, out-smartness and diligence can help you to outperform the market along with the points discussed above.

Is technical analysis important in making investment decisions? Is it helpful in selection of good investment opportunities and outperforming the market? Technical analysis cannot help you in outperforming the market, nor can it help in identifying good investment opportunities. However, it is a useful tool and can aid to time your entry and exit from the market. It has been seen that stocks follow a particular pattern. And once you have identified that you want to invest in X company, then with the help of technical analysis, you can decide when should you buy stock of X company and when should you sell it off.

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Appendices What investment strategy do you think investors should follow? Individuals should also adopt active management strategy. And also, risk profile will affect the choice of the strategy adopted by them. If investors want stable returns and are risk-averse they should adopt passive strategy. Moreover, since the investors do not have access to information and resources to analyse and understand that information as well as the fund managers do, they should invest in the market through professional investors, rather than doing it themselves.

Many researchers have proven that nearly all mutual funds and other institutional investors fail to beat the market on a consistent basis and that they underperform the market. In most of the instances, when they actually are able to beat the market, the costs incurred in their research and other expenses wipeoff the benefits. Can you explain the reasons for this? Or provide evidence when a fund or a company has been able to outperform the market over a consistent basis? Irrationalities and reasons why FMs underperform: - Thrill of out-performance that makes you take riskier option. When you start doing well, you start to increase your exposure in the market and put-in more money in the market, which is disastrous. - If a well-known FM has identified something, the others get into it, stories are built, hype is created and that sector becomes hot. This is a common mistake. In fact, at this point in time, smart FMs exist and make good returns while others just pile on into that stock and most of them end up losing money. Funds that have outperformed consistently: HDFC mututal Funds scheme called HDFC Euity, Sundarams mid-cap fund, Reliances growth fund, DSP Merrill Lynchs opportunity fund, DSP Merrill Lynchs Equity fund, Templetons Prima fund. Institutional investors are not able to outperform the market also because: - so many schemes they put the money into are designed in a way that they are not supposed to beat the market. Their motive is to generate safe returns for their investors. - Outperformance is not the motive of many schemes.

Investing for the long term means judging the distant future, judging how history will be made, how society will change, how the world economy will change. Reaching decisions about such issues cannot proceed from analytical

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Appendices models alone; there has to be a major input of judgment that is essentially personal and intellectual in origin. Do you think this statement is correct? Are subjective issues important in evaluating investments? Can you further elaborate this point from your perspective and give an example, from your own experience, when you identified a particular investment opportunity, long before it was popular in market and also detail on that. Yes I strongly believe that this statement is correct. Subjective issues lies in your judgment power, your skills and ability to identify good opportunities and analyse companies and stocks, how discipline you are in the market, capability and credibility of the management of the company you intend to invest in, etc are some examples of subjective issues that are important in decision-making. Own example is of Pantaloons Retail India Ltd.. I identified this company 5 years back when it was trading at Rs 30. My rationale was that there were very few big retailers in Indian markets into apparels and supermarket and only 2-3 of them had national presence and outlook of increasing their stores in India. Pantaloons was one of those three stores. The companys products and services were appreciated in the market, it was a new concept otherwise earlier people used to buy only through individual small retailers. I always try to map the US and UL markets and try to identify and watch what changes these economies had 50 years back and relate that to India, since it is an emerging market. So retail boom was what I envisaged and I was confident about it. It was a right decision and like I envisaged within 5 years the companys stocks are trading at Rs. 1600 from Rs. 30 in 2001-2002. 5 years back everyone was sceptic about Pantaloons performance and its retail concept. They were not ready to accept the change that will take place in the retailing market. But then this change was bound to happen because the Indian market is changing and consumers tastes and preferences are also changing. To some extent this change is aligned to the market patterns of other developed economies.

How important is Behavioral Finance in making investment decisions? Can you provide some examples of investor behavior (irrationality per se like herding behavior, over-pessimism or over-optimism) that causes inefficiency in the market from the Indian stock market perspective? And its Cause and effects? Behavioral Finance is indeed very important in making investment decisions. One of the examples is herding behaviour, herding without understanding why they are getting into a particular sector and without understanding why they are buying stock of so and so company. I will explain this through an example. It is 5.30pm, peak hours of local trains in Bombay (Mumbai). The train platform and train is very crowded. Someone was talking to his companion in a loud voice and was using the

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Appendices word Bombay and someone pushed him and he could only utter Bomb.. Few people heard his utterance and started shouting BOMB, BOMB, BOMB, and a rush of panic occurred in the station, everyone started running-off and started acting irrationally. No one even once tried to understand what happened and caused this irrational behaviour causing trouble. Exactly this is how the stock market participants behave in the market. If someone recommended buy, everyone will follow the advice without using their logic and so happens for the selling advice. Without understanding and knowing people just do as others do and even rational investors and professional managers follow the crowd.

Keynes pictures the stock market as a casino guided by animal spirit. He argues that investors are guided by short-run speculative motives. They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short-run price movements. What is your view about the Keyne philosophy and why? In regards to Keynes picture of the market, I think his explanation is correct and this happens in the market. But is this not what markets are for?

Do you think that markets price the securities correctly: - in short-term? - in medium-term? or - in long-term? Why? In a longer-term. Short-term markets are driven by irrational investors. For example, external events like a bombing in UK will result in crash of Indian markets despite the fact that such an event actually has not affected the Indian economy or its industries and companies. It is just panic from investors or an opportunity for speculators to make profits by driving the market away from its fundamentals. However, in a longer-term the true picture will show and prices will reach their intrinsic value, their efficiency.

Do you think that as soon as some information regarding a security is disseminated in the market, it is reflected in the price? Do stock market participants fathom the information correctly and act rationally or there is a discrepancy? No, there is a discrepancy. For example, the information that is disseminated may not be apprehended in the same manner as the company wanted to show. Each individual will understand and henceforth react in a different manner. In fact, existence of both

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Appendices the buyers and sellers in the market prove that same information is interpreted differently and there is rational and irrational action on the basis of that information.

Do you believe in the existence of overvalued and undervalued stocks as against the many researchers and investors who think that there is no such thing in the market, and it is just a way of fooling investors? Yes, definitely overvalued and undervalued stocks exist in the market. Markets are like a pendulum which swing between the phase of overvaluation and undervaluation.

How do you think should investors identify good investment opportunities? Through- Strong fundamental research - Disciplined investment methodology - Ability to identify excesses on both the sides up and down.

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8. Mr. Vishal Jain

Shruti: Do you agree with the EMH? To what extent do you think the theory holds true? Do you think that it is possible to beat the market? Do you think that Indian stock market is as efficient as the capital markets of other developed countries like US or UK? Why? Vishal: Agree with it. In my view, in India markets were not efficient 4-5 years back because the information was hotchpotch. But today the regulations in the Indian markets have improved from the stock markets and also the regulator. Information disseminates at the same time as soon as it is available and the dissemination is also higher leading to markets becoming more efficient. Besides, 3-4 years back there were only a few players in the market, mostly domestic institutions. But today even domestic institutions have become large, retail investors are becoming more educated, lot of foreign institutions and hedge funds have come into the market. So the competition level has increased. The research on the markets has improved manifolds. Now, there are more researchers, analysts, much more technically qualified people in finance than earlier. Therefore the markets are much more efficient than they were few years back. And over a period of time, Indian markets would become more efficient.

Shruti: Do you think that the markets always price the securities correctly? Vishal: Yes markets price the securities correctly. But claiming that it always does is a utopian idea. However, even today, if you have information that other people in the market do not hold, then you can make money out of the market and outperform others. Say insider information. But such chances are rare. But through public information and historical prices it is difficult to outperform the market.

Shruti: Is there a discrepancy between what the information holds and how people interpret it? Vishal: Yes and no. For example, a person may interpret a particular piece of information to be great but the other may not. For this reason only buyers and sellers both exist in the market. There will always be contrarian views. If everyone will view the information and interpret it in the same fashion then no market will exist.

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Appendices Shruti: What do you think about the argument that if everyone will pursue passive investment strategy then the amount of research carried out will diminish resulting in markets becoming inefficient? Vishal: In market there have to be active managers. Because the active managers are taking call on the market, the passive fund managers are there and exist. If whole market is passive there will be no market. India is developing market, therefore there would always be some sectors poppingup, which will give above-average returns and add value. For eg. Few years back no one talking about telecom sector. Suddenly it has popped-up and its a big story. And people have been able to get excellent returns through investing in this sector. Hence active managers can make money. When economy develops/grows, sectors and companies grow. They become large and competitive, so it becomes difficult for even one company to out-beat the others because mergers and acquisitions occurs, companies start consolidating and growth rate comes to average levels like what has happened in the developed markets like US, where a company growing @ 10% is considered big and good. But in India, if a company is not growing atleast @20-25%, it is not considered good because of the nature of our economy. So say in 5-10 years down the line India will also reach that stage and the growth level will reach average and companies will have growth level of say 8-10 % as against the 225% they have now. If you are a 100 million company you can grow @15-20% but when you become 10 billion then you cant sustain the same growth level. Indian companies are also reaching economies of scale and they are becoming big. Companies in India are now having 20k-40k employees which wasnt seen 4-5 years back. Having a year-on-year growth of 20% is not possible all the time. So in a few years time they will also come down to average and then it will be difficult for active fund managers to beat the market, as they are able to do now.

Shruti: In 2003 no one knew that market will reach from 4000 index-level to 13000 in 3 years time. In this period, investors who might have pursued indexing earned well. But before that period 1992-2003 the market did not do well. In fact it was stumbling down in that duration. So a person who pursued passive strategy in that period was actually worse-off for 13 years. Vishal: Obviously there will be periods when Passive fund managers will underperform compared to active managers but then even the vice-versa happens. Looking at this point of time, it is not necessary that active fund managers will outperform the market as they grossly did in the past. In developed markets like US and UK passive investment strategy is ingrained in people. $4-5 trillion is floating in index funds. There the index managers review the index on an active basis, there are constant changes happening to index. Companies which do not fulfil the criteria move out of the index. In India, companies are getting

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Appendices into the index on the basis of valuation and that valuation is on the basis of which the active fund managers are playing on. What is gradually happening now and will continue to happen is that Indices in India are getting reviewed much more often. And the criteria for Index companies being a part of index is also changing ad Index providers are also learning. But now gradually even the indices are going to get all the more efficient and they are going to select better stocks. Due to this, the instances of active managers outperforming the market are going to reduce.

Shruti: Research has shown that Active Fund Managers are not able to beat the market on a consistent basis. However, despite that there are people like Peter Lynch, Bill Giller who have done so. Do you think skill plays an important role and people with certain skills will always outperform the market? Vishal: Ya it does. Active fund managers have to be there otherwise passive guys will not survive. There has to be a guy who has to go wrong for some other guy to go right and vice-versa. There has to be research done on stock and there has to be a contrarian view in the market, in fact everywhere. Then only will both the philosophies will survive. So there is a role for active fund manager as well. When a client approaches us, we never say that put all your funds in indexing, even though we are purely a passive fund company. We always suggest them that a part of your portfolio should always be in active funds. Say if he has Rs. 100, put 25-30 purely in indexing, another 30-35 in active funds and the rest can probably be put in debt. Active funds also have value.

Shruti: What investing strategy should an investor follow? Passive or active? Vishal: I think it should be a combination of both.

Shruti: Why is that? Vishal: Simply because there are periods when active fund managers outperform the market and indexing doesnt generate returns. And obviously the skill is there and that skill of active guys should be valued. However, because an active manager has outperformerd the market this year doesnt guarantee that he will be able to outperform in the coming time. I dont want to take this risk. I might as well put my funds in an Index for 4-5 years and I believe in it because if our economy is going to grow, which it will, so obviously the large companies are going to benefit the most. I want to be invested in the best companies and that is reflected in the Index. I dont want to put my money with some Fund manager who might be there today but might not be there tomorrow, who is

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Appendices performing today but might not be performing tomorrow. I dont want to make that call.

Shruti: Do you think that the risk profile of an investor makes a difference in his investment strategy? Vishal: Yes, definitely. If the investor is risk-averse, he would probably prefer being with the index. He would not want 30-40% return that may not be stable, he is content even if he is just getting the market returns of say 20-25%. I am not sure that an active manager who has beaten the index can do so in the future as well and also that he will be able to beat the market by a huge percentage. The classical case of outperformance I have seen is the case when active fund managers are benchmarking their returns with the wrong index. There are people giving good returns say 40% (As against Niftys 20%), who are investing in mid-cap companies and comparing their index with Nifty Index. But obviously there is no comparison. So if you are investing in mid-cap companies, you should compare your returns with Mid-cap Index. Thus, when looking at the performance and returns of active managers, such factors should also be taken into account. I dont think it is possible for any active manager to grossly outperform the market on a consistent basis and with time it is going to get all the more difficult.

Shruti: Then what do you think about people like Peter Lynch and Warren Buffet who have been consistently outperforming the market? Vishal: They are exceptions. History shows that there are a very few people who have done it.

Shruti: In fact there are more than just a few people who have been consistently outperforming the market. So what do you think, it is their skill or matter of luck? Vishal: Im sure it is skill. If you are consistently doing it, there is skill. But how many people can actually do it, is a big question. Especially in India, I dont know who that one person is. There were people who were beating the market on a consistent people, but they are not there today.

Shruti: Institutional Investors (question 3) Vishal: Even if Fund managers and Institutional Investors are able to beat the market that number is going to be small and lot of their money is going to be eaten-up by the cost. So I agree with the statement.

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Shruti: What do you think are the reasons why Fund Managers are not able to beat the market? Vishal: In India, the expense ratio that is charged to the investor on an active fund is 2.25% of the assets being managed. We are the passive fund and we charge 0.25%. So an active FM has to first outperform the index by 2% to beat the passive guy and get at par at what Passive Fund is giving. So he (active) has to work that much harder. To what extent can he do that? The information dissemination is the same. What information we have, the active guy also has the same. So there is very little chance that he is going to beat the market. Eventually, he is also going to give the market return. If you look at the portfolio of active FMs, 80% stocks they have in their portfolio are there in the Index. This would mean that he is just going to play around with 20-30% of the stocks in his portfolio to generate returns higher than the market-returns, which again is a big call he is taking. So eventually he is also going to give you index returns. Simply because the psyche is that he also cannot deviate much from the index because of the risk that he might underperform. Everyone is looking at the Nifty, so they have to hold the Nifty stocks also. If he is completely off the Nifty and his selection goes wrong he would be in trouble and he would not want to take that risk. This is because he is benchmarking his returns with the index. So indirectly he is also tracking the index.

Shruti: Do you think there is a herding behaviour amongst IIs and FMs? Vishal: There is a herding behaviour across all the investors, forget about active or passive. I have seen that when the market falls everyone is there to sell and when the market goes up, everyone is in the market to buy. There are very few people who have the guts to really go out and buy when the markets are falling. For example, in May 2006, all the markets slumped and I saw that we were getting huge redemptions. It was surprising that no one came in and bought. People were ready to put in money when Index was 12000 but when Index is 9000 no one wants to invest or no one has the money or guts to invest at that time. Logically if you are putting-in money at 12000 Index then you should be willing to put at a 9000 Index level, when fundamentally nothing has gone wrong in the economy or companies, when the economic condition of the country is same and there is no problem. This behaviour does not make sense. When the Index again ramped-up at 11500, people again started buying-in and investing.

Shruti: So do you think that because of the pressure from investors to outperform the market or follow what is hot in the market, the IIs and FMs are not able to perform well.

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Appendices Vishal: Yes, there definitely is pressure and there is also peer pressure and all FMs are aware of that, and of them are quick to react to that pressure. That is why most of the active managers are also investing in Index. Most of the portfolios replicate the Index.

Shruti: If the manager or analyst stays disciplined, uses his judgement and does not act out of pressure and has the guts to go against everyone, do you think he will be able to outperform the market? Vishal: Yes I think so, he should. But see it is like the chicken and the egg problem. I mean even if he has guts to sit in the market and also sit with his portfolio even when he is underperforming and still believe in his philosophy but people should also have faith in his philosophy. But it does not happen. Even his fund is underperforming his clients will shift to other fund managers and then he will not have the money to manage. For people to have faith in him and his philosophy it would require exceptional skills and a lot of experience, because such faith comes with a lot of years of experience like it took Warren Buffett forty years to build his reputation. At the end of the day, it is business. I might have a philosophy but I got to survive in the market.

Shruti: Do you think as economy will grow, we will start reaching efficiency any passive strategy would be made popular and start working. Vishal: Definitely it will be and also there would be great regulatory push down from the regulators, In India we dont have huge domestic corporations barring VTI or a LIC or a General Insurance company whereas in US there is a huge pension fund market. In India there is a huge pension fund market but they are not allowed to invest in equity. Government is now talking a regulation called the OASIS report, they have this committee where they have mentioned that when the pension funds would be allowed to invest in equity it will only be through index funds. So that will be a big regulatory push towards Indexing like in USA. Once this happens, there would be a lot of institutions coming into index funds and getting into it. And once these guys come into indexing there would be a herd mentality again. Youll then find a lot of retail institutions getting in and a lot of talk happening about Index Funds and then a lot of MFs getting into it. This would result in lot of advertisements and marketing happening for indexing a lot of awareness coming into people and a lot of information flowing. So it will gain momentum as the time goes by. Thats what we believe in, we are the only Fund House into passive funds And we believe in the coming time the market is huge for Passive Funds.

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Appendices Shruti: What kind of stocks do you think institutional investors concentrate on? Is there a bias? Vishal: There obviously is a bias towards large cap stocks. But at the end of the day the MF and money managing companies in India and across the world has to survive and keep coming up with new ideas. So they have to have diversification in their funds. So what is the new idea I have come up with or the new story I have come up with? Say now I have come up with mid-cap funds and then I sell the mid-cap story. Thats why you nowadays find in India a lot of new mid-cap funds coming in. I have to keep generating the ideas and selling those ideas to people. So I come up with mid-cap stocks and generate the mid-cap story but then suddenly the mid-cap stocks are over-valued. The large-cap stocks are overvalued. So now whats next? Then I might shift to small-caps. Its a business and at the end of the day I have to survive in the market. I have to get the money, pay salaries & bonuses. So its like flavor of the month thats why today the whole flurry of investors are into mid-caps stocks & funds. There is a herding. At the end of the day I have to make money. I will have to generate a story and sell that to people. People will buy that story. So you have to first make that story, I have to make a fund and then I have to go & sell that fund otherwise I wont survive. If other FMs are selling a new idea I also will have to get into it. Shruti: Can you provide some examples of irrationalities on part of IIs because of which they are not able to perform well despite all the efforts they put in research & analysis? Vishal: Herd mentality not only from IIs but also from retail investors. Why is a MF also selling in the market? Because it is getting redemptions from retail investors, from its own customers. So that mentality goes across the board right from retail investors to MFs customers & FMs to institutions and all other players in the market. And that is very irrational. But I dont blame them. Because what happens is everybody panics, everyone craves. There is so much of information today and everyone starts creating a panic scenario like markets are going to plummet, the India story is over, you are going to loose, so that is irrational. In Indian market selling is very distributor led. MF companies are paying the distributors more and earning less. Its like a chicken and egg problem. If I dont pay them I will not get money. I think its a bone in the whole system, its the investors who are losing. Asset Management Company is earning irrespective of whether the investor is losing or earning. The FM is earning, the distributor is earning. Custodian, registrar, the accountant are earning their commissions or salaries but at the investors expense. The investor is being taken for granted.

Shruti: Does passive strategy allow you to do that, i.e. make subjective decision?

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Appendices Vishal: Passive strategy is a vehicle to use your judgment and take a call on. Passive FM never comes and asks you to make a call on the market. It is on the customer to do that. If the investors think market is going to do well he comes & invests through the passive funds because he does not believe in active fund manager & therefore he uses his own judgment. Shruti: What is your view on behavioral finance? Vishal: I think people have run out of ideas to beat the market and thats why all these things are coming up. Fuzzy logic. We have exhausted all active fund management ways, we have done all the kind of valuation models, different types of research and the passive investment also, so whats next? So therefore the behavioral finance has come up.

Shruti: Do you think that if peoples behavior causes inefficiency & they act irrational, so we can learn from their mistakes and outperform? Nobody has been doing consistently well. VISHAL: each strategy is bound to bomb at some point of time. I might invest according to behavioral patterns and some day it might bomb on my face. I dont know to what extent it would work, it is stable, does it work in different scenario. Every strategy bombs at some point of time. Some day this might go wrong & you dont know why has it gone wrong. Even if you try to understand people all the time you are not you will always be able to outperform, & outsmart them. And you wont know what else has gone wrong. For e.g.- if everyone investing in the market and buying in and the markets are going up, you might think that I will do the opposite because the people are stupid and you might shot. And the market might just keep going up, what you are going do then? Your judgment might go wrong. You might think that everyone is stupid and I am smart. And I am studying others behavior and I know what not to do. But that might also bomb on your face. Fundamental guys say technical is bullshit & technicalists say fundamental is crap But each thing has its own value. Fundamental also works at the end of the day you have to look at numbers. Similarly in order to time the market you also might need technical analysis. You might even need behavioral finance. So you need inputs from everything, and use those and the make your decisions. I dont think one thing works all the time. Dont base your decisions on just one thing. Base your judgment on all the inputs. All these things might work or might not work. So you got to take inputs from everything, inputs from fundamental analysis, technical analysis, behavioral finance and your own judgment.

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Appendices Shruti: Can you outline some of the irrational behavior of investors? Vishal: In India there is tip behavior. Without using their judgment & research people listen to the tips from the market and act on it. First time they go right, second they again go right. First time they put Rs100, second time they put Rs200 on that tip. They are happy & decide that this guy is always right & next time they put Rs1000 & then the market completely bombs on him. So basically they follow tips, it goes right once, it goes right twice it just bombs on you. Everyone out there is to make quick money, they dont look at it as investment. People in market are driven by greed. Need a disciplined approach, a proper asset allocation and a proper strategy to do well in the market.

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