Vivek Kaul: The New Year is teaching retail investors old lessons

The Nifty 500 Total Returns Index, a good representation of the overall Indian stock market, has fallen 11.3% since peaking on 26 September. 

A ‘total returns’ index takes dividends given by stocks into account while calculating returns. But like all averages, the Nifty 500’s fall does not give us the complete picture (All return calculations are as of 17 January.)

While the overall Indian stock market may have fallen by a little over 11%, some of the stocks in sectors around which strong narratives were built by those in the business of managing other people’s money (OPM) have fallen considerably more.

At a broad level, in the last few years, the OPM wallahs have really hard-sold the stocks of public sector enterprises (PSEs). 

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This narrative fed very well into the nationalism story that has been hard-sold by politicians in power. But the public-sector story is now unravelling. 

The Nifty PSE Total Returns Index peaked on 1 August. It has fallen by close to a fifth since then. A 20% fall requires a 25% gain to recoup losses.

Within PSEs, the railways has been a much storied sector. 

The Nifty India Railways PSU Total Returns Index, which comprises 14 companies either owned by the ministry of railways or catering to Indian Railways peaked on 12 July and has fallen by more than 26% since, wiping off a 35% gain.

Further, defence has been another much storied sector. 

The Nifty India Defence Total Returns Index, which is made up of 16 companies, has fallen close to 23% since peaking on 11 July.

These data points offer multiple lessons.

First, regression to the mean is at work. 

Or as Daniel Kahneman, Olivier Sibony and Cass Sunstein write in Noise: A Flaw in Human Judgement: “Extreme observations in one direction or the other will tend to become less extreme, simply because past performance is not perfectly correlated with future performance. This tendency is called regression to the mean."

Second, regression to the mean is more evident in some stock prices than others. 

Many stocks in specific sectors around which strong narratives were built by OPM wallahs are falling like a pack of cards.

Third, the narrative built around certain stocks and sectors got many retail investors to invest in such stocks, leading to a surge in their prices. 

As Sanjeev Prasad, Anindya Bhowmik and Sunita Baldawa of Kotak Institutional Equities write in a recent research note: “The number of retail shareholders has increased several-fold in such companies." 

This a classic case of stock market insiders (read OPM wallahs) setting up retail investors for a fall, and making money in the process, something which hasn’t happened for the first time.

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Fourth, mutual funds tried to cash in by launching new schemes around which narratives had been built. 

Take the case of the Motilal Oswal Nifty India Defence Index Fund, which was launched in June, around the time the defence theme peaked. 

It collected ₹1,676 crore, the highest ever collected by an equity index fund. The scheme has lost 9% in the last one month and 20.6% over six months, considerably more than the much broader Nifty 500.

Fifth, while narrative-driven stocks may have taken a considerable beating, that doesn’t mean that their valuations are now cheap. 

As the Kotak analysts put it: “Many of them have corrected sharply in the past 3-6 months, but most are trading at absolutely ludicrous valuations." 

In very simple terms, the point is that an extremely overvalued stock that has fallen 50% can fall 50% more.

Sixth, the recent stock market experience brings us back to a few fundamentals of investing. 

Diversification remains the most important game in investment town. Retail investors who bet their houses on investing in narrative stocks and are still holding on must be in real trouble now. They didn’t realize that return of investment is more important than return on investment.

Seventh, as mentioned earlier, the narrative around PSE stocks, defence stocks and railways stocks fed into an overall nationalism narrative. 

It worked for retail investors until it didn’t. And this inability of many to separate their politics from their investing must be hitting them hard now.

Also, stung by their current losses, such investors may be put off from investing in stocks for years to come, which would keep them away from a genuine means of wealth creation (if done properly). That’s another loss waiting to play out.

Eighth, the tendency of retail investors to look at what has been happening in the short-term and project it forward, as if it will continue forever, has come to the fore all over again. 

As Dominic Nolan writes in his crime novel White City: “Humans might recognise the long term, but in truth they [don’t] handle it much better than four-legged creatures."

Ninth, in all this, while foreign institutional investors continue to sell, having net sold stocks worth ₹44,396 crore (about $5.15 billion) in January, at an aggregate level, the zeal of retail investors for stocks hasn’t lessened all that much. 

The market for initial public offerings, for example, remains hot. 

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At the same time, the money coming into equity mutual funds is strong. In December, equity mutual funds saw net inflows of ₹41,156 crore. 

The moral of the story is that the OPM wallahs are still winning and that isn’t good news for retail investors.