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Playing Smart on Elections

Seventy-five per cent of market movements are due to short-term emotions. Smart investors would do well by ignoring the volatility caused by election results

Playing Smart on Elections

One of Warren Buffett's less well-known but very deep quotes is, "When 'dumb' money acknowledges its limitations, it ceases to be dumb." There's a lot of meaning in those 11 words. Conventionally, 'smart' or 'dumb' money mean exactly what they appear to mean. Dumb investors don't know how to invest, what to invest in, and when to invest in. What the grand old man of investing is pointing out is something almost all of us can can use because we've all been dumb investors more than we have been smart. Once you admit to yourself that there are things you don't understand about an investment or a situation, then you become, for all practical purposes, smart.

Which brings us to what seems to be the number one worry of every equity investor nowadays: what will happen to the markets after the election results. Not just that, what is driving the markets before the elections? Does the market as a whole know something that we don't? Is there some secret formula to reading the ticks that will tell us what the collected wisdom of the crowd is?

Basically, it's the same old question of what drives stock prices. There are a lot of answers and a lot of them are simultaneously wrong as well as right. Long ago, there was a study about what exactly drove stock prices. The idea behind the study was to look at how prices moved over a long period of time and then try and map movements to what was later delivered by fundamental economic and business processes.

The researchers found that three factors between them explained almost all what happened in the equity markets. The first was the productivity of the economy, its overall growth. This was a factor over the long term. The second was how much of the benefit of the economic growth ended up going to households. And the third was 'risk aversion', which is essentially people's reaction to uncertainty about the future.

This study came to the conclusion that 75 percent of the movement of the stock market is historically explained by this third factor. This basically means that the main short-term driver of the market are emotions. What people feel about what's going to happen is responsible for 75 per cent of the short term stock 'action'.

In the middle of the clamour for somehow knowing what will the election results do to the markets, this is something to pause and consider carefully. By itself, it does not matter what you know or do not know. Not just now, but even by the afternoon of the 23rd May, the way the equity markets will react will largely be driven by emotions. It will be a knee-jerk response.

Eventually, your investments in Indian equities are linked more than anything else to the broad growth of the economy. The elections' impact on the equity markets will be through that route and that route alone. The results of these elections will have a deep and lasting impact on the the economy--one would have to be really stupid to argue otherwise. However, this is an effect that will play out over years and perhaps even decades.

There will be plenty of time to choose your course of action after carefully study and calm thought. For the time being, ignore the markets and make sure you do the right thing with your vote.