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Getting it wrong...always

An exhaustive study reveals that due to several behavioral biases, Indian retail investors lose money even when odds are stacked in their favour

It’s been an unbelievably positive year for equity returns, given the fact that macro-economic fundamentals and corporate earnings have both deteriorated. The Nifty is up nearly 25 per cent per cent from December 2011 to December 2012. The Junior is up 44 per cent. The Midcaps are up 32 per cent. The Bank Nifty is up 50 per cent. Many other sectors have done well. For example, FMCG is up 48 per cent, realty is up 47 per cent, automobiles are up 40 per cent, pharma 31 per cent, etc.

Yet, a closer look at the data suggests that the average Indian investor didn’t profit from this impressive bull run. We know this because the bull run was driven entirely by FII inflows. Overseas portfolio investors pumped over Rs 1,21,000 crore into Indian equities last year – that’s more than $23 billion in USD terms.

When it comes to individuals investing in equity, the broad data indicates they were net sellers.

Indian mutual funds were net equity sellers through the year. They sold over Rs 20,000 crore net. Indian households pulled money out of equity as well – in part, this triggered the selling by domestic institutions who had to meet redemptions.

Balancing off net FII buying versus net domestic institutional selling, a large proportion of the shares that FII bought must have been sold to them by individual investors. Some of that money may have been reinvested by investors in small-caps. But quite a lot seems to have been pulled out of the market if we go by household savings data, which indicates lower direct equity exposure.

This may be yet another case of the herd of Indian retail investors mistiming the market and managing to lose money even during a large bull run. It is sad. But it shouldn’t be surprising. The Indian School of Business has recently released a huge study (actually a couple of studies using the same data) that suggests Indian retail investors usually lose money even when the odds are seemingly stacked in their favour.

The ISB study mines NSE data, tracking every trade in every single NSE-listed stock by a pool of 25 lakh retail investors, who operated in the secondary market between January 2005 and June 2006. This is undoubtedly the largest-ever exercise of its kind. It involved a sample of over 140 crore trades with a total value of about Rs 37,00,000 crore (Rs 37 lakh crore) on the NSE.

The study ignored the equity derivatives market, which also has quite a lot of retail interest. In effect, this means it ignored short-sellers who carry positions for more than a single session, since all equity cash trades are settled by end-of-day.

The retail segment accounted for 98 per cent of all equity trades in terms of numbers. In value-terms, the retail segment accounted for around 36 per cent of the market value of all equity trades. They made around 4 lakh trades a day. Given the frequency of trading, a fair number of the individuals in the sample tracked by ISB would be traders, rather than long-term investors.

During this period (January 2005-June 2006), the Sensex and the Nifty gained by around 60 per cent. It was part of the biggest bull run in Indian history and the bull market continued for another 18 months, till January 2008. The uptrend was very broad, with advances outnumbering declines across the entire market. Net of brokerage and taxes, the population of 25 lakh investors lost about Rs 8,400 crore. Since equities are zero-sum, the institutions who were their counter-parties must have made the equivalent profits.

During that particular period, a simple strategy of buy and hold on almost any stock should, on balance, have produced handsome capital gains. Yet retail investors over-traded and they consistently bought and sold stocks at the wrong time.

The ISB study isolated some major behavioural biases, which seem to explain the majority of poor trading decisions that led to losses. One is what is called the Disposition Effect in behavioural economics. Most of the investor sample usually sold their winners early and held onto losers for too long. This minimised their gains and maximised their losses.

There were other well-documented biases.The study found that retail investors’ trading patterns are very dependent on mood (called “affect” in psychology jargon) and the mood is in turn, very heavily influenced by recent gains or losses. Investors who had made even small gains in their recent trades tended to become hyper-active, trading far too often. Investors who had lost money in recent trades tended to cut down on activity.

What is interesting is that the quanta of gains and losses didn’t matter so much as the sign – negative or positive. A small loss caused despondency, while a small gain caused euphoria. Investors were happy if they made five small wins and one huge loss whereas they tended to be unhappy in the opposite situation.

This implies that most investors are psychologically incapable of handling some of the most profitable trading strategies. For example, trend-following strategies where an investor rides an established trend usually have a high rate of net profitability but a relatively low “strike rate”.

Trends fail more often than not. But when they fail, a smart investor will limit losses. When a big trend starts running into profits it can compensate for many small trend-failures. However, an investor who is over-influenced by the sign and strike rate will be uncomfortable with a strategy, where he accepts several small losses in the hopes of scoring an occasional multi-bagger.

The third big bias is of course, over-confidence. When a retail investor makes a winning trade, he tends to assume this is because of superior analysis. When he loses money, he attributes it to bad luck. Taken together, this leads to a high-risk attitude where the investor tend to punt more heavily than he can afford.

The study does confirm that most of India’s retail players are similar in behaviour to retail players elsewhere. But according to the ISB data, Indian retail investors show a larger disposition effect than individual investors from nations such as US, Japan, China and Finland. They book profits earlier and hold losses longer than their peers in other markets where such studies have been conducted.

The biases revealed by the study do indicate the practical advantages to being a passive mechanical investor. A passive systematic style will yield returns if the market trends up over the long-term. Having a system imposes discipline and rationality and tones down dangerously manic-depressive trading behaviour.

As mentioned earlier, the study would not have captured the gains or losses of the investor who was “long only” during the 18-month period. Most buy and hold strategies would have worked, assuming the investors eventually booked profits.

The study also suggests that around 4 lakh traders in the ISB sample – that is, roughly one out of every six individuals – made net gains. Some of them would have made large profits. The big winners would be the individuals, who possessed the discipline to diagnose their own behavioural biases and iron them out.

If you want to beat the market, you have to get past your own psychological weaknesses and biases. In practice, most traders who work their way past they biases do so through bitter experience and by developing systems with mechanical rules. Assuming such a system is robust, it will eventually make profits. It must be noted that “buy and hold” is in itself, a simple and robust system and any more complex system should be measured against the results of a buy and hold strategy.

Another point is worth making. Most studies focus on efficient markets or assume that a market is efficient. It is possible to argue that India isn’t really a strongly efficient market. There is a lot of asymmetry in information access. So the advantage is more for institutions versus individuals due to their better data-gathering resources and greater analytical ability.

The primary markets were certainly inefficient during 2004-2008, given the multiple scandals that time. There are still lots of questions about corporate governance in listed companies and there’s plenty of anecdotal evidence about information leaks. Any market – efficient or not – is also policy-driven and India’s arbitrary policy-making will always cause information gaps as well.