The stock market collapse that began in May 2008 has made Indian households more risk-averse. The share of equities and debentures in gross household financial savings fell from 12.8% in 2007-08 to 2.6% in 2008-09. Going forward, the composition of household savings is unlikely to change dramatically even as the market recovers. For most Indian households, bank deposits would continue to be the most preferred investment option, with a small minority venturing into the stock market, either by buying equities directly or indirectly through mutual funds.

It is an established fact that over the long term, equities tend to earn higher returns than any other comparable asset. If so, why don’t retail investors put their hard-earned money into the stock market? The problem is that though equities deliver superior returns over the long term, they are nevertheless prone to relatively high short-term volatility. The issue at stake is one of loss aversion—that is, the tendency to strongly prefer avoiding losses than acquiring gains. As economics Nobel Prize winner Daniel Kahneman and his colleague Amos Tversky aptly put it, “Losses loom larger than corresponding gains" (“Prospect Theory: An Analysis of Decisions Under Risk", Econometrica, 1979).

Illustration: Jayachandran / Mint

Investment decisions that stem from differential attitudes to gains and losses are an important theme in behavioural finance literature. The stakes of investing in the stock market are perceived to be so high that an average investor chooses not to gamble with something that he does not wish to lose. The problem seems to be compounded by the fact that individuals appear to evaluate their stock portfolio frequently, even though their investment horizon is long-term. Since equities are prone to relatively high volatility in the short term, potential losses appear to outweigh the gains.

If so, how can we encourage greater retail participation in the stock market? Perhaps an analogy would help. When one begins to learn swimming, an aid in the form of a float is a highly valued tool because not only does it reduce the probability of drowning, but it also builds confidence. Think of the float as a safe (risk-free) savings instrument; something like bank deposits. It is an invaluable tool when one ventures into the risky waters of equities. Even after one becomes a regular participant in the stock market, an investor would continue to put, and rightly so, some portion of his savings into safe instruments. Given this psychology, could marketing strategies aimed at increasing household investments in equities be altered in some way to achieve better results?

Here’s an example. It has been noted that laws that create net benefits for society but also involve costs frequently lack the necessary political support to be enacted. When two such Bills are evaluated independently, losses are comparatively more salient than gains. A recent study suggests that it is possible to combine two Bills into one such that loss aversion exerts far less influence and gains are relatively more prominent (“Policy Bundling to Overcome Loss Aversion: A Method for Improving Legislative Outcomes", Katherine L. Milkman, Mary Carol Mazza, Lisa L. Shu, Chia-Jung Tsay and Max H. Bazerman, Harvard Business School working paper 09/147, December 2009). As a result, the combined Bill achieves greater support even when the same information is presented in a bundled piece of legislation as in two independent Bills.

Similarly, marketing of two financial products together rather than in isolation can ensure that loss aversion exerts less influence on individual decision-making. For example, a number of banking organizations in India have their own mutual fund houses. It would be feasible to have a combined marketing strategy for fixed deposits and equity funds—two products with different return and risk characteristics.

The existing mutual fund products such as balanced funds, which try to build in safety by investing partly in debt instruments, do not make the cut. Even debt-oriented schemes are not risk-free and do not guarantee return. Hence, these are not substitutes for bank deposits. In addition, there is a wide variation in the performance of these funds, making it difficult for investors to choose a relatively safe fund. In contrast, if designed and positioned correctly, a marketing strategy that clubs bank deposits with equity mutual funds could encourage households to invest more in equities.

Recently, insurance companies have launched a new product that invests in the stock market but promises to protect investors from downside risk. Traditionally, the return from stock market investment is calculated based on the value of the asset at the end of the investment horizon. The new product calculates it based on the highest asset value achieved any time during the policy term. Such schemes appear to shield investors from downside risk arising from stock market volatility. Nonetheless, unlike fixed deposits, these schemes do not assure a specific return to the policyholder and are far less liquid.

It is commonly believed that in India, lack of financial literacy along with regulatory and procedural hurdles hinder retail participation in the stock market. There is no doubt that progress on these fronts is important. However, an eventual solution to the problem may lie in a more effective marketing strategy that appeals to human psychology.

Vidya Mahambare is a senior economist at Crisil Ltd. These are the author’s personal views. Comment at