I know nothing about stock prices. And worse, I get confused about the different valuations put on stocks in the media. And all this talk of the demand and supply of securities leaves me wondering whether I have learned anything worthwhile in school.

For instance, I was talking to a few `personal wealth managers', recently. I hoped to get some hints on ways to make my bank balance look a bit more respectable than it has been lately. The news, so they say, is all good. Apparently, there is only one way stocks could go from here and that's not down. This made me, as you might expect, rather happy.

But the rosy picture painted by various analysts also left me feeling a bit uneasy. For example, one analyst confidently predicts that Sensex will reach 45,000 in 25 years from now. Other estimates were slightly less ambitious. But even so, a fair number of analysts are ready to put their reputation on line, predicting Sensex values which are most often at wide variances with each other. I wondered how these men could be so confident about something that might happen so long away.

Many of these estimates depend on what is known as technical analysis, to `beat the market'. The guiding idea behind this technique is that stock prices follow some kind of repetitive and therefore predictable pattern. So then, it becomes a rather simple procedure to plot past price movements on elaborate charts to find the true present value of the stock.

Economists of course believe such methods are all an eyewash. It is not just that the success of technical analysis would make economists redundant in financial markets. We also believe financial markets are far too efficient to allow anyone to pick off profits so easily. If all technical analysts were on average as competent as another, then profit opportunities would have been arbitraged away long before any small investor like you or me got anywhere near the stock.

This idea is known as the Efficient Markets Hypothesis. Stock prices, in the absence of insider trading and manipulations tend to reflect accurately all the information available in the market. There are of course apparent patterns that creep into our stock markets. Stock prices do sometimes show cyclical patterns, but then so do randomly generated series. For example, if you were to toss a coin, you might get a long string of heads followed by a string of tails. But this makes it no easier to predict the next toss.

It has been found, for instance, that Indian stock markets do actually show some degree of correlation between changes in prices on one day to the next. However, this correlation is too small for any of us to really make a profit on this relationship.

So why not instead put your money in the bank and hold on tight to the interest it earns? The answer is that, all things considered, equities still earn your money a higher rate of return over the long term than any other class of securities or deposits. This is because, in investing in equities you are accepting the risk that the company you are investing in, may one day fail. So you will have to be a paid a premium over the returns you may get from a `risk-free' bond or bank deposit to induce you to invest in this company. This premium is known as the equity premium.

The equity premium for Indian stock markets is estimated to lie somewhere between eight and 10 per cent. Assuming our inflation averages around five per cent and growth at six per cent, the nominal riskless return should be 11 per cent. An equity premium of eight per cent should therefore assure you a return of around 19 per cent, on average. So if you started working at age 24, and invested Rs 5,000 in equities and kept reinvesting the proceeds, by the time you retire at 60, your money should be worth more than 25 lakh of today's rupees.

The question then becomes what kind of equity should you buy? Retail investors like you and me should forget about trying to `value stocks'. We just don't have enough information, even if we had the ability, to compete with the bigger investors. This makes it extremely unlikely we might capture any speculative profits over the long term.

There are some very smart fund managers out there who can tell you what exactly are the growth sectors, and other such technobabble. If you are like me, confused about which fund to turn to, there is a simple effective alternative. Try investing in what is known as an index fund. An example of such a fund is the UTI Master Index Fund.

Their rationale is simple. They don't try to pick winners and losers. They act on the aphorism that `a rising tide lifts all boats'. The returns to investment in an index fund accrue not from profits from speculation, but from the equity premium over the long run. What an index fund tries to do is to replicate a portfolio of stocks that accurately reflects the relative importance of each sector in the economy. Since the share of profits in an economy stays roughly constant, the growth of returns to investment in an index fund depends on the general performance of the economy in the long run.

These funds are also known as passively managed funds because once the index fund portfolio matches the market index, the fund manager has very little to do. But this means that the fund is able to avoid the transaction costs that more actively managed funds incur. This means you pay less as management fees to the fund managers.

In case you might think this is a second best alternative. Think again. Since the American stock markets are the biggest stock markets in the world, it follows that they should be able to attract some of the smartest talent in the world to manage funds. In spite of this, the fact remains that very very few (perhaps none) actively managed funds have been able to beat the S&P index. Why might you expect anything else to happen in Bombay?

And the best thing about these index funds is, you still don't have to know anything about the stock markets!!!

Copyright © 1999 Indian Express Newspapers (Bombay) Ltd.