Herd behavior drags investors towards overvalued securities.
Economic theory says human beings are rational agents and their investment ideas are goaloriented, evaluative, consistent and free from emotions. However, in reality, the investment behaviour of retail investors can often be irrational.
Data pertaining to BSE500 constituent stocksover the past five quarters—March 2017 to March 2018—reveal that stocks that small investors increased their stake in have underperformed the market substantially. Small investors are individual shareholders who hold nominal share capital of up to `1 lakh. There are 45 stocks small shareholders have consistently increased their stake in the past five quarters. These stocks have delivered point-to-point average returns of -4.3% between 31 March 2018 and 29 June 2018. The BSE500 index returned 15% during the same period. The underperformance is enormous as 34 out of the 45 stocks underperformed the market and 30 gave negative returns.
On the other hand, there are 89 stocks in which institutional investors increased their stake in consistently over the past five quarters. The average returns from these has been 48.3%, an outperformance of 3.2 times over the BSE500 index. Strangely, none of the stocks favoured by institutional investors find favour among retail investors.
Also alarming is the fact that small investors have sold stocks that on an average have outperformed the market. There are 85 stocks small investors have consistently decreased their stake in over the past five quarters. These stocks on an average have delivered 34.4% returns between March 2017 and June 2018. This implies that retail investors failed to identify good quality stocks and earned below average returns from direct equities. Says Arun Thukral, MD & CEO, Axis Securities, “Small investors do not understand intricacies like valuations of a company and its business. They have short investment horizons and aim for quick returns. Without thorough knowledge, they end up investing in high beta stocks, those that already have been in the news and runup significantly in the near past.”
Small investors don’t always choose well
They often fail to judge right and tend to hold on to stocks that do badly.
Source: Ace Equity. Returns are point to point absolute returns between 31 March 2017 and 29 June 2018. BSE500 index delivered 15% during the period. Constituent stocks of BSE500 index considered.
Behavioral finance helps explain the conduct of small investors. One important reason for the underperformance is the disposition effect. It is the tendency to sell stocks of which prices have risen since the time of purchase. Such stocks may have the potential to grow further, but investors book early profits. In other words, investors tend to sell the winners and hold on to the losers. The purchase price is taken as a reference point and accordingly investors avoid realising losses by holding stocks that fall in value. On the other hand, realising gains is perceived as a matter of pride and therefore, stocks that gain in value are sold.
The second reason why retail investors fail is overconfidence. This affects their ability to identify quality long-term stocks and evaluate investment risks. Overconfidence makes investors believe they are superior in identifying strong stocks and have a better market timing ability. Such beliefs lead to a high turnover, high transaction costs and thereby to poor performance.
Herd behavior drags investors towards overvalued securities. Investors have incomplete information when they copy the behaviour of other investors. They tend to ignore the information they own and follow the decision taken by others. For example, an investor may be following a stock and a sudden spurt in price and volume over the past few days may lure him to buy the stock. However, the investor may not be aware of the information that has led to the increase in volume and price. Moreover, such information may not be significant enough to justify the price rise. Thus, the herd behavior drags the investor towards an over-valued security that witnesses correction as soon as the market realises the value of the information.
In addition, investors have a strong likelihood of repurchasing a stock that they have earlier sold for a profit compared to stocks they have sold for a loss. This leads to unsophisticated stock selection that goes against the principles of fundamental analysis. Given the behavioral traits, what are the strategies small investors should adopt to improve their overall investment returns? According to Siddharth Khemka, Head of Research, Broking & Distribution, Motilal Oswal Securities, one must pick stocks that have a robust business model, whose products have perpetual demand and those with strong brand image. “Investors must hold such stocks in good stead in bad times. Moreover, one should refrain from over-exposing their portfolio to mid-caps and small cap stocks,” he adds.
Ankur Maheshwari, CEO, Equirus Wealth Management, feels retail investors should seek guidance from investment advisers while investing in direct equities. Alternatively, they could look at options like mutual funds that are managed by professionals, offer reasonable diversification and liquidity to enter and exit with ease. Talking about sectors small investors should bet on in 2018-19, Thukral says, “Auto and auto ancillaries, consumer durables and FMCG are likely to perform better as their growth prospects are expected to sustain.”