Don’t overlook the downside of India’s retail investment boom

As of June 2024, the total value of stocks held by Indian households, both directly and indirectly, stood at ₹134 trillion, equivalent to 44% of India’s gross domestic product (GDP). 

At the end of 2019, this was ₹42 trillion or 21% of GDP. At 44%, it is in line with the 30-55% range observed in most advanced economies that the economists looked at, but significantly lower than 161% of GDP in the US.

This increase is also visible in the number of unique mutual fund investors more than doubling since March 2020 and the number of unique demat account holders nearly tripling.

Also read: Analysis: Retail investors remain undaunted, but what are they betting on?

This has led to more money flowing into listed stocks. As Ananth Narayan, a wholetime member of the Securities and Exchange Board of India (Sebi), pointed out in a recent speech, from 2015-16 to 2020-21, mutual funds, other domestic institutional investors (DIIs) and individual investors net invested an average of ₹40,000 crore each year in secondary markets. 

Since 2021-22, their average annual inflows have reached around ₹3.1 trillion, nearly eight times the previous level. Mutual funds and DIIs largely invest money they collect from individuals in stocks.

Further, individuals have also bet big on trading in financial derivatives like futures and options (F&O), which derive their value from stock prices and indices made up of stocks. 

A bulk of this increase has come through increased trading in index options, which has gone up over 12 times from 2019-20 to 2023-24. In comparison, the trading of stocks has gone up only over two times.

The trouble is that individuals have been losing big money in F&O trading while financial institutions have profited. As a Sebi study released in September noted: “The proprietary traders earned about ₹33,000 crore of gross profits (i.e. trading profits before accounting for transaction costs) in F&O segment in 2023-24, followed by foreign portfolio investors (FPIs) who earned about ₹28,000 crore in gross profits. Against this, Individuals and others incurred a loss of over ₹61,000 crore." So, money lost by individuals was the money that institutions made.

Now, this increasing financialization with individuals and households betting big on stocks has many side-effects.

Also read: Everybody loves a good old dumb retail investor

First, what investor George Soros calls the theory of reflexivity comes into play; that is, stock prices can impact the fundamentals of the underlying economy. 

So, as stock prices have risen, the well-to-do who own a bulk of the stocks have felt richer and have spent on premium products, leading to what stock market experts refer to as the increasing ‘premiumization’ of the economy.

Second, as Gupta and Ladha note, as of June 2024, investments in stocks account for 28% of the gross financial assets of households, up from 17% as of end 2019. 

This brings reflexivity into the picture again. If, in time to come, stock prices fall or stagnate, it will hurt consumer spending that is driving the economy’s current premiumization and growth.

Third, rising stock prices benefit those who already own stocks, who are largely those at the top of the wealth-pyramid. So, economic growth that depends on the value of financial assets going up worsens inequality.

Fourth, as stock prices have soared, promoters and their investors are selling shares through initial public offerings (IPOs) at valuations that their company earnings don’t justify. 

This implies that retail money coming into the stock market doesn’t just go into listed stocks. As Sebi’s Narayan put it, “We need issuers… to step up to the opportunity, raise risk capital from our willing investors, deploy it and create new businesses."

Fifth, popular fascination with stocks and derivatives has changed the composition of bank deposits, with individuals holding less. When individuals buy stocks, the money stays within the banking system and moves from one account to another. 

With a surfeit of promoters and their institutional investors selling shares through IPOs (and also in the secondary market), the money is possibly moving from individual accounts to corporate accounts. The same is true when individuals lose money on financial derivatives.

Indeed, as of March 2019, individuals held 55% of bank deposits. By June 2024, their share had fallen to 51.9%. At the same time, corporate holdings of bank deposits rose from 20.5% to 23.8%.

Now, individuals tend to hold deposits for longer tenures than corporates, helping banks balance their longer-term loans. But with this change in composition, the proportion of longer-term deposits as a proportion of overall deposits has come down, increasing the asset-liability mismatch that banks face.

Also read: India’s Chief Economic Advisor cautions against financial market’s role in policy making

To conclude, while market cheerleaders will continue cheering for a sustained rise in stock prices, there are several negative effects that are possible and it’s important that we at least talk about them. With due apologies to Bob Dylan, the executioner’s face may not always be well hidden.