Sensex to BSE 100 : Is it downgrading!!??

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.

Diversification and Employee Stock Option

Employee stock option is the option given to an employee by a company, to buy stocks of the company at a particular price in the future. ESOP is usually given to employees to boost their morale by giving ownership in the company, which is linked to their performance. The reason behind ESOP is that the employee will work hard to improve the performance of the company, which in turn will improve the company’s share price. ESOP has gained more importance in the past decade because of the tax incentives which it got, when compared to bonuses. But in the recent past this advantage has reduced by the imposition of taxes by the government.

Diversification is the process of reducing(hopefully) your risk in savings by investing in wide range of products. The range of products should be negatively correlated with each other so that when one investment reduces in value the other will increase, thus giving a cushion against losses. Diversification is considered very important to avoid the pits of short and medium term fluctuations in the markets.

Now the question in everyone’s mind is “What is the connection between employee stock options (ESOP) and diversification?” One can consider the time they spend in their job as an investment, and the salary they get as return for the time. Since employee spends at least one-third of his time in his job, this assumption becomes very important. Also in the same line, the salary increments and the promotion that the employee expects can be considered as the future expectation from the investment. So when an employee is investing almost one-third of his life in the company, is it a prudent decision to invest his savings also in the same company? Isn’t this against the basic reasoning for diversification?

I am not telling that ESOP is bad for everyone. But care should be taken when one accepts ESOPs. The terms and conditions under which the ESOP is given should be scrutinized before exercising the option. Employee should not be lured into the hype around ESOP and accept it. He should consider it as another of his investment and try to take an informed decision. ‘Overconfidence’, one of the key concepts in behavioural finance, is one of the biggest hurdles that the employee has to overcome to take an informed decision. The employee thinks that he knows a lot about his company and is overconfident about its returns. But rarely does anyone knows about the real status of the company, other than the top management (good example for this is Enron). Think of a situation in which the company goes bankrupt, the employee looses both is job and his savings, which is a catastrophe for any employee.

Therefore an employee who believes in diversification should be very careful before he accepts his ESOP.

I will be happy to discuss about any difference in opinions regarding the above view . Looking forward to many interesting discussions.