Leave the retail investor alone

There is widespread interest in retail investor participation in the Indian equity market. The government appears keen to encourage retail participation, evaluating how secondary offerings in government-owned stocks can best be set up to attract greater retail investments. Newspaper articles routinely complain that retail investors are not investing enough in the stock market, despite the recent stellar performance of the Indian index.

A contrary view is that retail participation, especially via the burgeoning equity derivatives market, is predominantly speculative and unsophisticated, resulting in wealth destruction rather than wealth creation. Recently, a number of influential editorials have called for increased regulation of retail investors, especially in equity derivatives markets, in an attempt to shepherd them towards what they view as more constructive investing habits.

This has, perhaps predictably, generated a backlash against additional regulation in what is perceived to be an over-regulated market environment to begin with.

Which view is correct? Should Indian retail investors be allowed to participate in equity markets in a relatively unconstrained fashion, or should their participation be more strictly regulated in an attempt to modify their investing behaviour?

This is an important debate, and one that would benefit from anchoring in hard facts. Unfortunately, there is not a significant amount of publicly available data or analysis which details the behaviour of investors in Indian equity derivatives markets, so opinions are being formed by analysis that uses broad information about equity derivatives trading volume. But such aggregate information makes it virtually impossible to arrive at definitive conclusions.

Fortunately, we can learn something from the detailed analysis of retail investor behaviour in the Indian stock market, where excellent data is available, and has been carefully analysed.

Using data on the investing behaviour of roughly 12 million retail investor accounts in the Indian stock market (approximately 60% of the total) over the past decade, my co-authors and I find that the average Indian retail investor does indeed look relatively unsophisticated on a number of dimensions suggested by standard finance theory.

The average Indian retail investor is under-diversified, holding a small number of stocks rather than a broad-based index; churns his or her portfolio significantly, thus incurring substantial transaction costs with potentially few rewards in the way of investment profits; and holds on to losing investments for too long, preferring instead to sell winning investments, a mistake in a market in which there is significant momentum in stock prices. This apparent lack of retail investor sophistication mimics results from a number of analyses of data on retail investors around the world, and Indian retail investors appear no different.

So does this mean that we should go ahead and regulate the way in which they participate in equity markets? I don’t believe so. The key lies in the other results from our analysis, as well as a number of important issues surrounding the impacts of regulation.

While the average Indian retail investor does appear unsophisticated, the picture looks quite different when we contrast the behaviour of “rookie” or first-time retail investors with “experienced” retail investors that have spent a few years in the market. With every additional year of investing experience, the analysis shows that there is a significant reduction in the incidence of investment mistakes. For example, the tendency to churn investments reduces by roughly three-quarters of the average for an investor with five years of experience relative to a rookie investor, a substantial amount. Indian retail investors seem to learn from their investing experience.

What’s more, the beneficial effects of experience seem to show up in the performance of Indian retail investors in the stock market—experienced retail investors significantly outperform the BSE index over the decade from 2002 to 2012, while rookies significantly underperform this buy-and-hold benchmark. In other words, the most experienced Indian retail investors beat the market—and this result holds even after we adjust for investment risk in a number of standard ways.

To my mind, these results suggest that there are evolutionary forces at work. Even in the absence of intrusive regulation—an ever-present feature of the Indian economy—retail investors appear to learn better investment habits over time.

But can we augment this process of learning with regulation? I think not. The distorting incentive effects of regulation are self-evident in the Indian economy. “Regulatory arbitrage” is a game played over and over by financial institutions and individuals alike, suggesting that regulation leads market participants to learn about gaming the system rather than playing the game. Given what we know, increasing the regulatory burden on Indian retail investors appears unwise—I suspect that the market will develop sophistication, left well alone.

Tarun Ramadorai is professor of financial economics at the Saïd Business School, University of Oxford, and a member of the Oxford-Man Institute of Quantitative Finance.

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