Here's how you can cut risk while investing in shares

At a time like this, when oil prices are sliding and the markets are extremely volatile every person is a guru – exhorting one to buy a particular share whereas another encourages one to sell that particular share. No one really knows and its difficult to predict. Random Theory, I believe, gains credence at this time.

J P Morgan the elder is reputed to have retorted to a naïve acquaintance who had ventured to ask him what the market was going to do, "It will fluctuate," Morgan said. Some shares would rise while other would fall. It is not possible to predict. As Bernard Baruch, the Wall Street wizard once remarked, "If one is correct half the time, he is hitting a good average".

The random theory of investment is based on the premise that there is no logic in share price movements; that prices will rise and fall on whims and by the manipulations of individuals and that there is no need to study trends and movements of prices prior to making an investment in shares. A share purchased at random, on a whim, is likely, it is argued, to be as successful as another purchased after days of contemplation and thought. It pays credence too to the mob instinct, that people are like cattle; that people follow the crowd. If one buys all buy, irrespective of whether the share is a good buy; whether the share is worth the price or not.

The theory (which has also been called 'the great fool theory') is best illustrated by an actual happening. The editor of the Forbes magazine, to prove that share prices acted illogically stuck the stock market quotation pages of the New York Times on the wall of his office and threw 10 darts. Two darts missed the target. On the basis on the eight darts that actually hit the target he invested a hypothetical $28,000. The prices of these hypothetical investments were monitored closely. In 15 years, they had appreciated 3.6 times whereas the capital appreciation of the share price-index of Standard and Poor was only 2.6 times.

The random theory gained weightage from the fact that the two basic methods of predicting prices – fundamental analysis and technical analysis are not completely accurate. Dalal Street is not an exception to the random walk theory. Jandhyala L Sharma, in his doctoral dissertation at the University of Arkansas, presented substantial evidence to prove that price movements at the Bombay Stock Exchange followed a random pattern. His study was based on 131 monthly observations during a ten-year period of the Bombay Variable Dividend Industrial Security Index published by the Reserve Bank of India. His sample was also supplemented by 268 weekly prices of 23 shares on the specified list of the BSE. Sharma came to the conclusion that prices at the BSE showed randomness, and that randomly selected shares can outperform shares picked out by cold sound logic and reasoning. This is its greatest merit.

What really are the other advantage of this theory? There are a few:

(i) As shares are picked at random – without preference or evaluation or bias the question of good or bad (or any) judgement does not arise as no judgement takes place. This makes it easier for persons who have no idea of the stock markets to invest.

(ii) As shares are picked at random there can be no question of following the crowd. Hence, one is insulated against the dangers of the crowd being wrong.

(iii) The investment decision can never be ill-informed as no information is sought or consulted before the investment is made.

(iv) As the shares purchased are selected at random and without bias the chances of accumulating a balanced portfolio are large. As the shares are likely to cover a diversified group of companies, the investment would be protected against industry risks and cyclicality. The returns too are likely to be reasonable and usually above average.However there are pitfalls.

(a) The random theory lays the investment decision beyond the investor's control in as much as the shares purchased are chosen in a manner where the investor has no control on the share that will be chosen. As a consequence too much dependence is placed on ladyluck and if luck is against the investor, he stands to lose a lot of money. But then randomists counter this with, "audentis fortune juvat – fortune favours the brave".

(b) On a random selection it is possible for one to pick dogs or lemons – shares that have no potential or hope to grow in the foreseeable future.

(c) The random theory is speculation at its best – the belief that prices will and must rise and that shares will rise come what may. The obvious danger is that prices could fall and one may be plain unlucky.
There are three factors to remember:

(i) Technical and financial analysis cannot guarantee superior returns. It cannot outperform a simple buy and hold strategy in the long run.

(ii) One must diversify one's portfolio as much as possible. This eliminates the risk that is inherent in individual companies.

(iii) The random theory also advocates the need to create a long term period as studies have proved that the random theory is not effective in a short term.

The random theory above all vindicates that price movements cannot be predicted with certainty over a period of time and this makes the game exciting and enthralling. Throw your darts and join the game. At this time there is nothing else you can do.