I want to discuss about something that has been in my mind for a long time now. Actually the heading itself clearly explains this something, that I have in my mind. But let me explain it in detail for those who didn’t get it.
When a stock is removed from Sensex and added to BSE 100, the stock price usually goes for a dive. Actually just the announcement of the change by the exchange will cause such a panic, that the sellers will be lined up without much buyers. This creates downward pressure on the stock price and the pressure will mostly be there till the change actually happens. It almost seems like a downgrade given by the stock exchange for a particular stock. What really happens in this situation? Is it really like a downgrade? Do the fundamentals of the stock go for a dive with this change? What happens to the stock which gets added to Sensex?
First of all it surely is not a downgrade. Why will the stock exchange give a downgrade signal for any of the stocks? The exchanges are there just to facilitate the smooth transaction of the securities. So they won’t do the brokers job of downgrading and upgrading a stock. Usually the stocks in the Sensex are stocks with highest market capitalisation (there is some calculation regarding this). So when another stock, through market forces, achieves higher market cap than a stock in Sensex, it might replace a stock in the Sensex. This decision is usually taken by the exchanges.
Therefore these changes are done without any reference to the underlying fundamentals of the company. This clearly shows that these changes are in no means a reflection of the future performance of the company. So without any underlying change in the fundamentals of the company, the stock price of these companies becomes very volatile (which to an extent explains market inefficiency). This also holds good for the stock which has been added to the Sensex. The prices of the stock which gets added to the Sensex moves upwards. What really makes these stocks volatile, that too just with an announcement?
My take in this is that it has everything to do with behavioural finance. Most of the retail investors think that Sensex is a superior Indices than other broader Indices and come to the conclusion that when a stock is removed from Sensex it is a bad signal. The traders, who are always in the lookout for chances to earn money, grab this opportunity and try to drive that stock down. Retail investors link this initial decrease in price to the announcement about the stock being removed from Sensex. Therefore they start to sell, which puts more downward pressure on the stock. This starts a negative feedback, which is actually nothing but more and more people selling just because the price is going down. This clearly explains that, one announcement by an institution (exchange), which has nothing to do with the fundamentals of a company, can drive the price of the stock up or down. This I think is market inefficiency (if am wrong correct me).
There is actually one reason, which according to me is a valid reason for this decrease in stock price. The index funds, which exactly follow the composition of Indices will have to buy and sell stocks according to the changes in Indices. Since there will be more Index Funds following Sensex than other broader Indices, the stocks present in Sensex will be bought more. So when a stock is removed from Sensex there will be selling pressure, which will drive the stock price down. But this should happen only when the stock is moved from Sensex to BSE 100, and not with the announcement itself.
I will be happy to discuss about any difference in opinions regarding the above view . Looking forward to many interesting discussions.
Rational decision making is never ever experienced- starting from sale of eggs to sale of stocks, irrationality exists. Market inefficiency is inevitable in this case as the best the markets can do is to ensure there is no information asymmetry. How this information is interpretted by the masses is unfortunately not in the bourse's control. In fact, Warren Buffet once said- "I'd be a bum on the street with a tin cup if the markets were efficient."
ReplyDeleteSo to this extent, inefficiency is good- coz the whole logic of transaction in financial products is based upon the fact that there exists a difference between the assessment of the value of a financial instrument between the buyer and the seller.
I am also a believer of Market Inefficeiency and why should it be good or bad!!It is just Inefficient... But professors in the west who are trying to prove this are having a tough time disproving Market Efficiency... They have to fight with Great Minds like Sharpe(remember SAPM-Sharpe model)in this regard... So each paper regarding Market Inefficiency is scrutinized like hell before they are accepted... Luckily now Behavioral Finance is getting the much needed attention, which can explain many of the Market Inefficiency... but lots of research is still due in this new line... Sharpe called Warren Buffet a "Three to five Sigma Effect" that is Buffet's success is probable but not replicable...and Warren Buffett once commented, "You couldn't advance in a finance department in this country unless you taught that the world was flat"... So it is too tough to disprove that "World is Flat".
ReplyDeleteReally good one.
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