Everybody loves a good old dumb retail investor

In a city full of tourists wanting to touch, feel and see the sites where J.K. Rowling got the inspiration for Harry Potter, there was no one around the grave of Adam Smith when my younger sister and I went visiting late in the evening. In fact, I got the feeling that the grave wasn’t even well-maintained.

But that’s life. Everyone, however great, eventually gets forgotten, even Adam Smith, a man who in the last few centuries possibly had more impact on the world at large than anyone else, other than perhaps Karl Marx, who came a few decades later. Even Edinburgh seems to have forgotten a real hero for a fictional Harry Potter.

As I walked up the road next to Adam Smith’s grave, the headline for this piece popped up in my head: Everyone loves a good old dumb retail investor. Or rather, the headline popped up in my head and I made up the details later. Of course, people who have a serious reading habit would know that the headline has been inspired from P. Sainath’s lovely book Everybody Loves a Good Drought. And that’s the thing with serendipity and when it strikes. In my case it made sure that Smith met Sainath.

Why does everybody love a good old dumb retail investor, especially those in the business of making money from other people’s money (OPM)? Well, because they make money from the mistakes made by the dumb retail investor.

Before getting into details, let’s look at data from two recent documents released by the Securities and Exchange Board of India (Sebi). One was titledStudy - Analysis of Intraday trading by Individuals in Equity Cash Segment, and the other,Consultation Paper on Measures to strengthen index derivatives framework for increased Investor protection and Market stability.

1) Around a third of individuals who trade in stocks do so on an intraday basis—they buy a stock and then sell it the same day by the time the stock market closes. The number of such intraday traders increased from 1.5 million in 2018-19 to 6.9 million in 2022-23. These numbers are limited to the top 10 brokers.

2) Most such traders are young. The proportion of intraday traders under 30 years of age had stood at 18% of overall intraday traders in 2018-19. By 2022-23, it had grown to 48%, implying that one in two traders carrying out intraday trading are young. The rise of cheap smartphones backed by an even cheaper internet along with the launch of many apps with easy-to-use interfaces are some of the major reasons behind this phenomenon. Then there are financial influencers funded by stock brokers peddling the nonsense of how easy it is to make money from the stock market. Of course, the lure of easy money, envy and greed remain the other major reasons. Is youth unemployment also a reason? To say this with confidence will need more research but it cannot be discounted as a possibility.

3) Not surprisingly, a bulk of these intraday traders have lost money. In 2022-23, seven out of 10 traders (71%) in the intraday cash segment (buying and selling stocks) lost money. This proportion was 65% in 2018-19 and 69% in 2021-22, telling us that more of the newer lot is losing money. Also, the number of intraday traders coming from smaller towns has gone up dramatically. Given that most of them seem to be losing money, this will have both economic and social implications. Further, those in the tier-I cities seem to be making the most money.

4) Again, not surprisingly, the higher the turnover the higher the proportion of loss-makers—the more a trader buys and sells, the greater their chances of losing money.

5) The proportion of loss-makers is inversely proportional to age. Those under 20 years the highest proportion of loss-makers (81%) and those over 60 years had the lowest proportion of loss-makers (53%). It is interesting to see that even in the lowest proportion of loss-makers, more than one in two traders actually lost money in intraday trading.

6) Individual traders who carried out more than 500 trades in 2022-23 incurred an average loss of ₹61,394. The cost of trading was over and above this. As the study points out: “Loss-makers who were trading very frequently (undertaking more than 500 trades in a year) expended 72% as cost of trading over and above their aggregate trading losses during 2022-23." Basically, to cut a long story short, a bulk of intraday traders lost money.

7) What about those trading in financial derivatives? As the consultation paper referred to earlier points out, in 2023-24, 9.25 million individuals and proprietorship firms traded in the index derivatives segment of the National Stock Exchange and incurred a trading loss of ₹51,689 crore in total. In fact, 99% of these individuals traded in index options and only 7% traded in futures. On average, 85 out of every 100 individuals trading in index derivatives lost money. Taking the cost of trading into account, nearly nine out of 10 individuals would have lost money.

Further, as Ananth Narayan, a whole-time member of Sebi, said in arecent speech: “The net trading loss borne by individuals… is nearly a third of the net inflows into growth and equity-oriented schemes of all mutual funds during 2023-24. These are certainly not insignificant and indicate that money that could be put into constructive capital formation is being frittered away at scale."

So, if individuals are largely losing money by trading stocks intraday and in financial derivatives, who is making money? As the Sebi consultation paper points out: “It has been observed that larger non-individual players that are high-frequency algo-based proprietary traders and/or Foreign Portfolio Investors (FPIs), are, in general, making offsetting profits." As always, the big fish is eating the small fish. But that’s just one part of the game.

Transaction costs have to be taken into account as well. Stock brokers make money through the brokerage fee they charge the traders and the rebate they get from stock exchanges for driving up trading volumes. (For a detailed understanding of this, read this).

The exchanges make money by charging the brokers a transaction fee, which the brokers pass on to the traders. The government makes money by charging a securities transaction tax every time a trader buys or sells. The financial influencer is paid by stock brokerages for promoting the idea that it’s easy to make money from the stock market, in the process helping drive up trading volumes, which helps brokerages earn a rebate from the stock exchanges. Everyone makes money except the good old dumb retail investor, which is why everyone loves them.

This story isn’t just limited to intraday trading in stocks or trading in financial derivatives. It happens elsewhere as well. Mutual funds are launching new schemes to collect money from retail investors when valuations are extremely stretched. In the public domain as well as off the record, mutual fund chiefs talk about how stretched valuations in some sectors are, and then they go back to their offices and launch equity mutual funds investing specifically in those very sectors. 

Or they launch funds with general jibber jabber themes such as business cycles, consumption, innovation or special opportunities, where a fund manager can practically invest in any stock and justify it with some fancy English.

In fact, there is nothing new to this strategy of launching new schemes when stock valuations are absolutely off the charts. It has happened in the past as well. I had written about this in detail in Mint recently. In 2007-08, as the stock market went from strength to strength, a new equity mutual fund scheme was launched almost every week. In total, 55 new equity schemes were launched during the year, collecting ₹43,028 crore in total.

Most of the schemes launched were essentially similar to schemes asset management companies (AMCs) running mutual funds already had. So, why launch new ones? Ultimately, the more money an AMC manages, the more money it earns. And it so happens that it is just easier to sell new schemes when the stock market is doing well than old schemes.

The stock market peaked in January 2008 and then the story changed. While in 2007-08, AMCs had raised ₹43,028 crore through 55 schemes, from April 2008 to May 2017, they launched 264 equity mutual fund schemes that managed to raise a total of ₹42,540 crore.

In June 2017, four new equity MF schemes were launched and these collected ₹1,957 crore. It was at this point that the money collected through new schemes post 2007-08 crossed the money collected just during 2007-08—a period of more than nine years.

This happened because AMCs had chosen to launch new equity schemes in 2007-08 at a time when stock valuations were very high. Retail investors who had rushed to invest in equity MFs either lost money or earned very low returns once the stock market crashed after January 2008.

 

Of course, AMCs make money out of the total amount of money they manage, and not on the profit they deliver to the retail investor. So, irrespective of whether a retail investor makes money or not, the AMC gets to keep a percentage of their investment—which is why they are very interested in getting investors to invest at a time when the stock market is at really high levels.

This also explains why fund managers keep egging on retail investors to invest more and more in stocks. Buy on dips. Buy when stock prices are going up. Buy when stock prices have crashed. They really don’t have an incentive to say anything else.

Or take the case of what happened between 2008 and 2011, when insurance companies and their agents went about aggressively promising investors that their investment would double in three years. Of course, it didn’t. The retail investors lost but the insurance companies and their agents are still around and they are still trying to pass off unit-linked insurance plans as mutual funds.

Or take the case of what happened in 1994, when fraud promoters launched initial public offerings (IPOs) left, right and centre, and took the hard-earned money of retail investors and disappeared. This was India’s biggest stock market scam, which practically everyone seems to have forgotten.

Or take the case of the rate at which promoters are selling shares right now, something I wrote about recently in Mint. A recent news report in Mint quoting data from Prime Database points out that in the first six months of 2024, promoters or owners of businesses had sold stocks worth ₹62,000 crore. This is the highest in six years, for which the report shared data, and only half the year has gone by.

Now, promoters are the ultimate insiders. The kind of information access they have about their own companies no one else does. And when so many of them sell at the same time, what it basically tells us is that they feel their share prices are overvalued, and that they don’t expect the future earnings of their companies to rise at a pace that justifies the recent rise in share prices, and so there is money to be taken off the table, and this is why they are selling. They may have reckoned they could buy back their holdings later at a lower price.

Then there is the specific case of promoters who are selling their stakes in companies through initial public offerings and driving up nationalistic fervour to get retail investors to buy shares in their companies being sold at extremely high valuations.

In fact, this is a point that economic historian Charles Kindleberger made in his all-time classic Manias, Panics and Crashes: A History of Financial Crises, which was first published in 1978: “As the boom continues… the purchases of securities… by ‘outsiders’ [read retail investors] mean that the ‘insiders’ [read promoters]—those who own these assets—sell them and realize profits; if the outsiders are buyers, then the sellers must be insiders."

Which is why everyone loves a good old dumb retail investor. Of course, a part of the game is regular repetition by those in the business of managing OPM that the Indian retail investor has matured. But a lot of data and historical examples have shown us that this so-called maturity is a story being sold to the retail investors so that they can feel smarter than they really are. You have to first pull them up only to throw them down later.

That brings us to the final point. Intraday trading in stocks or financial derivatives is no way to make a living. Of course, there will always be successful exceptions to this rule, those who make good money from doing this. And hats off to them. But most of us aren’t intelligent enough or mentally strong enough to make a living like that. We may think we can. But as data clearly show, we can’t.

Which is why individuals need specialisations they can make money from. I know mine. I have the blessings of Mr Smith, whose grave I just visited in Edinburgh, Scotland. I am hoping to seek the blessings of John Maynard Keynes and Karl Marx the next time I go to the United Kingdom.

Dear Reader, who is blessing you? Or are you happy being a good old dumb retail investor? Okay, not dumb. But just good-old, good-old?

To conclude, let me get back to the story I started with. I keep walking up from the Canongate Kirkyard and end up at the Blackwell’s book shop at the South Bridge in Edinburgh. Of all the bookshops I have ever been to, this has to be by far the best. Not too big. Not too small. Just the right size where almost every section gives the prospective buyer a huge bang for the buck. Mr Smith is clearly watching over me. What about you?