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Why do Analysts Love Sensex Targets?

...because they can tell stories about a company on days other than when companies come out with results

There have been a spate of analyst reports in the recent past predicting that the BSE Sensex will go through the roof in the years to come. This writer has seen numbers ranging from 28,000 points on the Sensex next year to 1,00,000 points in 2020.

The basic exercise is very simple. A number is decided and then calculations are done to figure out what kind of returns would help achieve that number. So, take the case of the target of 1 lakh points by 2020. For something like this to happen, the Sensex needs to give a return of 26 per cent per year, over the next six years (assuming that it is at 25,000 points right now).

Once this is figured out a credible sounding story needs to be built around it. The story that everyone wants to hear right now is that the newly elected Narendra Modi government will set right, everything that is wrong with the Indian economy. And we will be up and running again. This will lead to higher economic growth and a booming stock market.

The analysts coming out with big Sensex targets are mouthing the same story as well. They are playing a very important part in telling the investors what they want to hear. Other than telling the investors what they want to hear, there is another important reason behind these Sensex predictions. The stock market operates five days a week and around 250 days a year. During this period, the listed companies declare results on four days. They may also have some important information to share on a few other days during the course of the year.

But stock brokers need new stories to get investors to buy and sell stock all through the year. As Andy Kessler writes in Wall Street Meat, “The market opens for trading five days a week… Companies report earnings once every quarter. But stocks trade about 250 days a year. Something has to make them move up or down the other 246 days. Analysts fill that role. They recommend stocks, change recommendations, change earnings estimates, pound the table-whatever it takes for a sales force to go out with a story so someone will trade with the firm and generate commissions.”

The Sensex targets are a part of this game as well. Adam Smith (not the famous economist but an American money manager writing under a pseudonym) makes this point in The Money Game. As he writes; “They (i.e. the stock brokers) could put you in some stock that would go up ten times, but then they would starve to death. They only get commissions when you buy and sell. So they keep you moving.” And targets are an important of keeping an investor moving.

Any broker who would have asked his clients to buy and hold Berkshire Hathaway stock in 1965, would have not made any money in the process. But the investors would have grown fabulously wealthy. The stock could be purchased for $12 in 1965. It is currently worth around $1,89,000.

Another reason why analysts come up with big Sensex targets is because there is something known as the anchoring effect at work. Behavioural economists Amos Tversky and Daniel Kahneman ran a small experiment to show this effect. They rigged a wheel of fortune which stopped only at 10 or 65, even though it had numbers marked from 0 to 100. They then asked some students to be a part of this experiment. One of the economists would spin the wheel and ask the student to write down the number on which the wheel stopped. Since the wheel was rigged it stopped either at 10 or 65.

After this, the students were asked two questions. Daniel Kahneman writes about the experiment in Thinking, Fast and Slow. The first question to every student was whether “the percentage of African nations among UN members” was “larger or smaller than the number you just wrote?” The second question was “what is your best guess of the percentage of African nations in the UN?” The wheel of fortune did not give any information regarding the questions that were asked. But it still influenced the answers that the students came up with. “The average estimates of those who saw 10 and 65 were 25 per cent and 45 per cent, respectively,” writes Kahneman.

The estimates that people made of the percentage of African nations in among the UN members was close to the number that had come up, when the wheel of fortune was spun. This effect is referred to as the 'anchoring effect'. And it is an important part of the financial hype that stock market analysts indulge in. As John Allen Paulos writes in A Mathematician Plays the Stock Market, “Often, it seems an analyst cites a 'price target' for a stock [or an index target] in order to influence by putting a number into their heads...The reason for the success of this hyperbole is that most of us suffer from a common psychological failing. We credit and easily become attached to any number we hear.”

In fact, more distant the future is, the greater is the impact of the anchoring effect. As Paulos puts it; “The more distant the future the numbers describe, the more it's possible to postulate a huge figure that is justified...by a rosy scenario.” When it comes to stock markets a lot of information is available and hence, a sensible sounding story can always be built around the big number.

Another reason going for the analysts is the fact that most people do not think about returns in compounded terms. Let's say an analyst were to predict that the Sensex will touch one million points by 2050. While it might sound like a huge thing, it is not. For the Sensex to reach that level, it needs to give a return of 10.8 per cent per year over the period. The Sensex returns since 1979 have averaged at a little over 17 per cent per year. To conclude, it is best if investors take these targets with a pinch of salt.

Vivek Kaul is the author of Easy Money. He can be reached at [email protected]

This column appeared in the August 2014 Issue of Mutual Fund Insight.