DON'T TAKE STOCK MARKET AS SOCIAL SECURITY INVESTMENT VEHICLE

Only fools rush in

ALI FARID KHWAJA
Mar 20 - 26, 2006

Once again there has been a major downturn in the Karachi Stock market and questions are being raised about the fairness of the system, existence of market controls and allegation of fowl play by the big investors.

This is not new to the market, as almost similar events followed the market crash last year, in the same month. Whereas the onus of the blame for the March 2005 crash resided in part on the badla providing brokers and hence there was some legitimacy on the demands of those who had lost money to raise hue and cry, the case of March 2006 is simply an outcome of over-exuberance on the behalf of the investors and hence merits nothing more than sympathy. The point I want to make is this: Whereas the last crash came after a long period of a bull run, and hence there were many investors who may not have perceived the true risk of the market, the bubble of March 2006 came after the investors had a recent experience which should have taught them the dangers of over-exuberance. Since the same mistakes were repeated by the investors, and although most stocks were highly over-priced by all measures, investors continued to rush in after the perceived gold mines, which didn't exists, I label my thesis as 'only fools rush in'.

The stock market is not a social security investment vehicle. It does not safeguard the capital and as finance academics would like us to believe, the returns are only as good as the risks associated with them. So if a stock is generating high returns, chances are that the risks associated with it would also be high. A market failure could have existed, which would have merited intervention by the regulator, if the investors were not aware of the risks of the market. This is exactly what happened last year, as long period of Bull Run coupled with euphoria created by the media-government-businessmen might have led to the perception that the risk profile of the Karachi stock exchange has improved. This time however, the investors had all the reasons to be aware of the risks associated with investment, there was enough information available that the market was over-heating and so still if anyone chose to invest, it shows that he was going for the high returns conscious of the risks, hence there is no market failure. The argument that big brokers, especially those who run their book, manipulate the market in their favour and are to be blamed also doesn't hold its ground. Although there is clear published evidence (see Dr. Asim Khwaja's paper titled 'Phantom markets, how equity markets do not function') that there is indeed manipulation by big investors who act in concert to manipulate the prices and who corner the stock, the point which I would make is that it does not matter! Most investors have enough information to be aware of the market manipulations in the Karachi Stock Exchange, and indeed there would be hardly anyone who would be na´ve enough to expect an efficient market at operation. So if investors know of the market manipulations and know that the big investors have a higher (even if manipulated), probability of winning, and still they invest, it shows they are willing to take the risk. If the risks are willingly taken for the sake of superior returns, then there is no need to protest over it.

This leads us to the imperative question, why do investors, especially small investors take the high risks in the hopes of gaining higher return, when they know they would lose? It is like playing a gamble with clear odds of losing. However, this seemingly irrational risk appetite of the small investors is not completely irrational. Equities, the only high return asset class in Pakistan, which is also liquid enough and where small investors can invest (unlike in real estate where large denominations are needed). Lack of social security investments, along with poverty, lowers the risk aversion of the small investors, making them play dangerous gambles. Lets take a hypothetical example. If I have PkR10 and someone offers me an investment (gamble), which gives PkR1000 with probability 0.2, and PkR0 with probability 0.8. Although I know that the odds of losing my PkR 10 are far more, I would be willing to take the risk as the gains are higher (though with less probability) and even if I don't take the bet I would not be able to achieve much with PkR10. So put in more technical jargon for the economists reading this, the coefficient of risk aversion first increases with wealth and then after a certain threshold, it starts decreasing again (implication: very rich and very poor people can take larger risks). Hence if this indeed is the problem, the solution could be in providing instruments for social security, like pension funds, etc. Also the NSS bonds still offer near zero percent rates. If inflation has to remain in the levels of 8% and above, then investors should be offered higher return on their savings.

The bigger problem in my view, is the lack of alternative investment vehicles, lack of free float and of hedging instruments. In any other market, investors could have used derivatives to pass on the risk when the market seemed to be overheating. In KSE, the only option, which the investor has, is to liquidate his portfolio, which is not a cost free and easy option. In fact liquidating the portfolio to avoid the risk, would lead to crashes in the market. Unfortunately, the Commodities Exchange is still not operational. If there were more assets like commodities, an active debt market and perhaps REITS, investors would have more options to diversify their investments and in way could hedge against unfavourable movements in one of the markets. An increase in the free float, which is currently a mere 20% of market cap, would also reduce the chances of market manipulation and make the market more efficient. The new management of the SECP should move ahead with plans to introduce new asset classes and hedging instruments. Reforms have to be robust to political pressures; otherwise they fail after leading to considerable transaction losses.

The author is a Rhodes scholar at Oxford.