Direct stock investing may be thrilling but consider the risks

The retail investors’ enthusiasm for equity investments that got a fillip with the dual enablers of time, thanks to work from home, and a rising market shows no signs of waning. Demat and trading accounts continue to see new investors signing up. Apart from the thrill that being part of a market upswing gives an investor, the underperformance of equity funds, especially large-cap funds, relative to the market index may also have acted as a catalyst to increased participation in direct equity stocks.

Has the steep climb back by the markets post the March 2020 sharp decline lured investors into a false sense of comfort with direct equity investing?

The risks faced by retail investors getting into direct stock investing are well-known. These primarily come from the limited ability to pick the right stocks and time the investment, the lack of resources to hold a diversified portfolio, and the inability to manage behavioural impulses, especially when markets correct.

Even as stock markets scale new highs, it is good for investors who may find themselves unprepared to deal with a market correction to have some guard rails to mitigate the risks.

The intrepid investor

Due to the covid-19-led lockdown, a large number of people working from home had time on their hands, surplus money since spending was limited, comfort with online trading transactions and enough stock picks and recommendations on tap. “India is a very under-served equity investing market. So the interest is a positive development,” said Gaurav Rastogi, CEO, Kuvera.in, an online mutual fund platform.

For investors who have made money with ease in this run-up, Rastogi suggests a reality check. “Can you articulate what your investment edge is that will make your stock portfolio outperform? Do you have access to information ahead of the rest of the market? Do you have an analytical edge that makes you process information better or a behavioural edge that helps you build discipline in investing? The first two are unlikely for a retail investor compared to professional fund managers. The last can be a genuine source of competitive edge but it is the toughest edge to cultivate given the deluge of information that prompts investors to trade frequently to their detriment,” he said. If investors honestly answer these questions, they will see how the gains in the recent past are more chance than skill.

As long as these investors see this trading-dominated foray into equity markets purely as a tactical play and not adopt this as a long-term investing strategy, the risk may be contained. “Don’t get swayed by beginners’ luck. Set targets and exit, whether you are making gains or losses. If you lose money, it is a lesson learnt. Leave it at that,” said Santosh Joseph, CEO and founder of Germinate Wealth Solutions LLP.

The cautious explorer

The steep rise in stock markets post the March 2020 correction also caught the attention of those who have adopted long-term goal-based investing as their strategy. They saw this as an opportunity to test their favourite theories on how to beat the benchmark indices. While the recent rally may have vindicated their ideas such as investing in a few stocks and making gains from frequent trading, these strategies won’t hold well in a typical volatile market.

A study by Kuvera to understand if investors were better off directly investing in markets compared systematic investment into 275 largest stocks over a three-year period to that in a Nifty index fund. SIP in direct stocks gave an average return of -0.9% as compared to 4% in the index fund. Only 90 stocks earned better returns than 4%. The challenge for investors was to identify one or more of these stocks, which requires skill and time, which most retail investors don’t have.

Naveen Julian Rego, a Sebi-registered investment adviser and certified financial planner, accepts this need to include direct stock as part of his clients’ investment strategy, but he has some checks and balances in place. One, he sets a minimum investment limit in equity funds so that there is some experience of equity. Two, he draws up a shortlist of stocks to make the selection process easier. For investors who want to exercise their skills to the fullest, he recommends limiting it to 5-10% of their equity allocation. “There should be a clear segregation between their long-term portfolio and tactical investments,” he said.

The unsatisfied seeker

The market correction also lured investors who were looking to fill the lacunae in their professionally managed portfolios. These included taking exposure to stocks and sectors that they were bullish about, investing in small-caps that had poor representation in large-cap-oriented portfolios and taking advantage of momentum in specific themes.

While their concerns may be genuine, investors need the skills to be able to identify the opportunities in the markets and to assess the impact on their portfolios. “Investors whose expectations have not been met may even be unwilling to consider data that may show that the alternative they are considering may not have had better outcomes. They will best learn from going through the experience,” said Rastogi.

Rego added that staying with a well-thought out asset allocation and not allowing direct stock investments to alter this significantly will help such investors manage the risk.

what investors can do

Investors looking for greater control over their investment portfolio may consider exchange-traded funds (ETFs) that give the advantages of a diversified portfolio and real-time prices. Rego said ETFs, which use filters such as value, quality and volatility to fine-tune the portfolio, can be used for nuanced direct market investment and that too at low cost.

He added that investors may also consider selecting from stocks that form part of the indices as a way to mitigate risk.

It is also important for investors to keep behavioural challenges at bay. Chasing investments that recently saw a significant run-up, refusing to exit one that is under-performing (in some cases, adding to it), and not selling investments that have gained significantly to rebalance the portfolio are all manifestations of emotional biases that affect the efficacy of direct stock investing.

Costs and taxes will further cut into any short-term gains.

Investing directly in stock markets can be exciting when markets are in an uptrend. But investors should do it with caution and after due consideration of the impact it will have on their financial well-being when equity markets revert to their normal state of volatility.