Surge of first-time stock market investors: A warning sign?

It feels like the moment when sidelined investors, fatigued by waiting, are now compelled by frustration—perhaps even desperation—to dive into the market. The disciplined patience that kept them at bay has given way to an urgency to join the action.

Who are these investors? (Note: I’m generalizing here.)

They are typically drawn to stocks that are already in motion, the market's hot favourites. The idea, endorsed by some market gurus, is that what's moving will keep moving—momentum, they call it. The allure of "easy money" is strong.

Interestingly, mutual funds seem to be a distant second option for these investors. The reason? Returns from mutual funds don’t roll in as quickly (potential losses aren’t factored into their decision-making). 

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The mutual fund industry is attempting to address this by pushing thematic and sectoral funds, which promise more movement. But let's set that aside for now and focus on the influx of new money into the markets.

The allure of momentum

There's a noticeable influx of new investors, and broadly speaking, they seem to be chasing stocks and themes that are currently in vogue, with little regard for long-term consequences.

Consider the data on demat accounts opened in India: after a brief lull, interest has returned with a vengeance. This influx is like opium for the markets—new investors mean new money.

But where is this money going? Since the data on mutual funds is very readily available, let’s use that as a benchmark. This is the data for July 2024:

Data from mutual funds provides a clear picture: investors are chasing hot themes, sectors, and, of course, small caps. It’s safe to assume that some of this capital is coming from new investors eager to ride the wave.

What should we make of this? Are we at a peak of market greed?

The short answer is that no one truly knows.

But there are two important points to consider.

First, the obsession with momentum is fuelling the markets. New money flowing into the stock markets and high-octane funds continues to sustain the rally. This momentum is the insurance underwriting the market’s persistent bullishness. In this environment, every dip is seen as a buying opportunity, making prolonged corrections increasingly rare.

As long as this dynamic persists, the rally could potentially continue—perhaps even escalate into a melt-up, the classic sign of market-wide peak greed. This phenomenon may already be evident in certain market segments, though not across the board.

Second, regardless of whether the market has reached peak greed, much of the money entering now, without adequate risk controls, is likely to yield disappointing returns. The current prices in these segments already reflect a significant amount of future growth, meaning that for new investors to see substantial returns, something extraordinary would need to happen. That’s a lot to expect given the already lofty expectations built into the stock prices—at least in the hot segments.

Strategies for new investors: Caution and patience

This leads to two pressing questions during this euphoric phase: Will the momentum trade ever unwind? And how should a new investor navigate this situation?

Predicting when the momentum trade will unwind is impossible. Despite near-constant, massive selling by foreign institutional investors (FIIs), the impact has been minimal, underscoring the strength of this momentum. In the long term, market direction will inevitably hinge on the earnings and growth that companies actually deliver. But in the near term, many unpredictable factors are at play. Attempting to forecast them is futile, so we’ll avoid that pitfall.

While you can’t control the broader market, you can control how you approach it.

For newcomers to the stock market, consider this strategy:

First, if you understand stocks and have the time to manage a portfolio, focus on finding stocks that still offer value. These are not easy to find, but with diligent effort, they’re out there. Resist the temptation to chase momentum stocks. Your guiding principle should be to "pay a fair price (or less) for a great company" and then hold onto these companies for the long term. This approach, while simple in theory, should form the foundation of your stock selection process.

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Second, if you lack the time to manage a stock portfolio or prefer to diversify some risk, mutual funds remain an excellent option—provided you choose carefully. Look for a tried-and-tested, long-term-focused fund management team, and give them the flexibility to manage your money across the market. flexicap or focused funds are good choices. Select one or two funds, and that’s it. Investing in mutual funds can be that straightforward.

To further mitigate risk and avoid getting caught up in a peak-greed scenario, spread your investments over several months. This method allows you to gradually ease into the market rather than making a large, potentially ill-timed entry.

Finally, above all, ensure your asset allocation is aligned with your specific needs. This is the ultimate way to optimize your risk-return balance and significantly increase the likelihood of achieving your financial goals in the long run.

As the market roller coaster continues, I wish you well on your investment journey.

Rahul Goel is a finance and publishing professional with over 25 years of experience in the industry. You can tweet him @rahulgoel477.

You should always consult your personal investment advisor/wealth manager before making any decisions.