Retail traders lost Rs5,584 crore a year due to bad calls4 min read . Updated: 11 Dec 2014, 07:41 PM IST
Adventurism in stock markets can have serious consequences for wealth accumulation
There is a problem known as the disposition effect. In simple words, disposition effect is a tendency to close a profitable position early and hold on to a losing position longer, hoping that prices recover. An artificial reference price, which is usually one’s purchase price, drives this behaviour.
Researchers working at the Centre For Analytical Finance at Indian School of Business, after examining terabytes of data pertaining to trading behaviour of retail and institutional investors, found that trading done by behaviourally biased and short-term oriented retail traders leads to wealth transfer from individuals to institutions. Although I use the words ‘investor’ and ‘trader’ interchangeably here, the real focus is on short-term trading done by individuals. The findings described in this article are not applicable to value investors who don’t indulge in speculative trading.
There is a debate in academic finance regarding the impact created by retail traders in the market. Retail investors are mostly dubbed as noise traders, who adversely impact the price efficiency of the market. Some have argued that such excessive short-term trading scuttles the functioning of arbitrage mechanism by increasing the deviation between actual price and the expected price. However, others have argued that presence of retail investors provides liquidity to the market and hence, is useful. The recent spurt in behaviour finance research has led to a careful examination of consequences of short-term trading on an individual’s wealth. One of the findings that has emerged is that excessive retail trading leads to transfer of significant amount of wealth from individuals to institutions.
Sankar De, Naveen R. Gondhi and Subrata Sarkar, in a paper titled Behavioral Biases, Investor Performance, and Wealth Transfers between Investor Groups, investigate the impact of trading on a retail investor’s portfolio in India. Specifically, they tested if there is wealth transfer from individuals to institutions in India. For the purpose of this study, the researchers used tick-by-tick trading data given to them by one of the exchanges. In total, they examined 1,346 million trades done by 2.5 million traders/investors. The monetary value of trades examined was about 37 trillion. Retail investors were involved in 831.5 million trades that they studied.
The purpose of the above description is to show that these results have come forth through a careful analysis of a very large data set and not based on casual observation of a few wise men. The study covers a period of 18 months between January 2005 and June 2006. This time period is relevant currently because the market was in a bullish mode even then. In fact, the CNX Nifty recorded positive returns in 15 of the 18 months that were studied.
It was found that when an investor with low degree of expected bias (read, mostly institutions) trades with an investor with high degree of expected bias (read ,mostly individuals), then the price of the stock traded moves in favour of the former. In other words, price of a stock usually goes down after retail traders buy it from informed institutions, and vice versa. Interestingly, such a pattern is not visible when both sides are likely to be informed or uninformed. Wealth losses of individual traders get accentuated when financial instructions happen to be on the other side of their trade. Financial institutions seem to be more informed than other institutional investors such as companies.
The economic magnitude of the losses experienced by Indian retail traders is large. The researchers estimated that, in their sample period of 18 months, retail traders lost 8,376 crore, a run rate of 5,584 crore a year. They also estimated that the loss due to wealth transfer equals 0.77% of India’s savings during 2005-06. It is important to note that the above figure only includes trading losses. If other expenses such commissions, taxes and so on are added, then the total loss easily exceeds 1% of the savings. The paper also indicated that behavioural bias shown by individuals in India is much higher than the same for developed countries.
This is not to say that retail investors should not invest in stocks. Careful research has clearly established that disciplined value investing generates positive abnormal returns. Such studies have also shown that equities tend to outperform other asset classes significantly in the long run. However, very few retail investors sustainably follow this approach. Many of them get attracted to short-term speculative trading and end up losing money even when it’s a bull market.
The findings of the above mentioned paper has two clear messages for the retail investors in India. First, it is futile to try to outsmart the smart money in the short term. When buying a stock sold by institutions, it is important to investigate the reasons for such a sale. Second, those investors who do not have time and energy to do such an investigation are likely to do better if they chose to invest systematically either in a professionally managed fund or simply a passive index. Adventurism in stock markets can have serious consequences for wealth accumulation.
Prasanna Tantri, associate director of Centre For Analytical Finance, Indian School of Business.