From UPSC perspective, the following things are important :
Prelims level : Not much
Mains level : Paper 3- Stock market and risks involved for individual investors
Despite gloom in the economy, financial markets are scaling new highs. The situations calls for diligence on the part of individual investors. The deals with this issue.
What influences investors’ decision
- Investors may not necessarily be always sensible or even capable of perceiving the larger picture.
- Nobel laureate Daniel Kahneman argues that humans usually use the ‘first system’ of ‘fast thinking’ to hurriedly act and perceive their environment.
- Consequently, they are susceptible to the ‘priming effect’, ‘framing bias’, ‘anchoring effect’, ‘overconfidence bias’ and ‘availability heuristic’.
- These phenomena, thus, play their part in pervading optimistic market conditions.
- As a result, investors often end up ignoring or overlooking uncertainties and risks involved in their decision.
- At the same time, investors’ decision choices could be significantly influenced by ‘nudging’.
- It is a deliberate tactics and method of behaviour modification by which it is the ‘choice architect’ that decides who does what and who does so, as argued by the Nobel laureate, Richard H. Thaler.
- The present surge in the Indian stock market is indeed nudging individual investors to trade more.
What makes individual investors vulnerable
- National Stock Exchange data indicate following trends:
- The share of the non-institutional individual investors in equity trading volume has risen to one half of the total turnover. in 2021.
- It was around a third in 2016.
- In contrast, the share of Foreign Institutional Investors (FIIs) in the total trading volume has shrunk to just about a tenth, it used to be one fifth in 2016.
- Trading in the stock market, the sudden rise, the intraday moves, etc., are, thus, attributable largely to individual traders now.
- However, despite their large trading volumes, individual investors have actually contracted their holding of the market capitalisation.
- The FIIs currently own around half of the free float of all Indian companies.
- Apparently, the retail investors have constantly sold their stake to end up holding less than 20% shares now.
- Trading, thus, seems to be the mainstay of retail investors and this is what makes them more vulnerable to the vagaries of the market.
Market is ignoring macroeconomic factors
- Centre for Monitoring Indian Economy Pvt. Ltd. data of the listed companies reveal a rise in their profit, due to rationalisation and cost-cutting.
- Investors might be tempted to ignore macroeconomic factors and invest in such stock believing that it is the profit that impels the stock prices.
- In reality, however, share price is expected to ascend if a company declares to cut its wage bill.
- This probably explains why stock markets around the world have been on the rise amidst the novel coronavirus pandemic; demand may have declined but profits have been least impacted.
- At the larger economic level, however, real wages have plunged.
- Clearly, the market has not entirely decoupled itself from the economic indicators.
- Established wisdom suggests that corporates cannot sustain contraction in the economy for long.
- Sustained decline in demand caused by waning disposable household income would catch them soon.
- Robert J. Shiller attributes this phenomenon of creating a possible bubble to irrational exuberance.
- When bubbles burst, they cause a kind of financial earthquake, in turn destabilising public trust in the integrity of the financial system.
- Critically, as the past portrays, individual investors, with all their vulnerabilities, suffer the most devastating consequences.
- Retail investors are as well susceptible to overreaction when negative news hits the market.
Consider the question “What are the factors driving the financial markets up despite the weak macroeconomic foundations? What are the risks involved in such situation for the individual investors?”
History of financial markets is replete with bubbles and bursts. Most affected in such burst are the individual investors. Informed decisions based on information and risks involved should form the basis of investment by individual investors.