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Professor Sankar De has recently been in the news because of his research findings that suggest that Indian retail investors tend to lose in the stock market. He writes about his influential study, which is touted as one of the largest in behavioural finance.
Is Zero Return a Natural Benchmark for Investors? An Investigation with Individual Trading Records
In this study, my coauthors Bhimasankaram Pochiraju (ISB) and ex-CAF researchers Naveen Reddy and Rahul Chhabra who are currently PhD students in the USA, and I document certain intriguing patterns about trading and investment decision of retail investors in India. We find that they consistently chase a zero rate of return on their stock investments when they make the investment decisions themselves This is without factoring in the transactions costs such as brokerage commission and trading tax etc. In other words, inclusive of transactions costs their benchmark return is negative. On the face of it, the finding sounds absurd. Why should anyone in his or her senses consistently make wealth-destroying decisions? Why do they not learn from their mistakes? They may not be conscious of it, but in effect that’s what they do. Our careful analysis of the trading records of millions of retail investors in India indicates that they increase both buying and selling if their trades in the recent past are marginally profitable or barely in the positive territory, and decrease them if they are unprofitable or in the negative territory, ignoring transactions costs. At the same time, they appear to care much less for the size of the same outcomes (gains as well as losses). But since on an average they lose more than they gain, the other side of the market being institutional investors who are usually more informed as well as more rational, the trades of the retail investors end up being value-destroying for themselves and beneficial for the institutional investors.
What makes the retail investors behave this way? We research this question too, and find that the culprit is a combination of two powerful behavioral instincts. One, the compelling influence of zero as a goal. The distinction between positive and negative numbers is of fundamental importance to human thought processes in many areas, not just investments. The distinction has been considered important for ages, but particularly since the sixteenth century when zero as a number became widely accepted in the western world. We instinctively become happy when we are in the positive zone, regardless of our pursuits, and become dejected when we are in the negative zone. Two, a well-documented behavioral trait known as “threshold mentality” in psychology. In all our endeavors, we seek a threshold to evaluate our performance. Zero makes for a natural threshold.
To conduct this study, we have considered every single trade by every single retail investor in each stock registered with the National Stock Exchange (NSE) of India over an eighteen-month period. Our sample includes 1.7 million retail investors who collectively carried out 230 million trades with a total value of over six trillion rupees over the period.
At the end, we must point out that the Indian retail investors are not the only behavioral or irrational investor group in the world. Separate studies conducted by other researchers in the USA, China, and Taiwan have also found that the investors in their samples also make consistently irrational and value-destroying decisions. Interestingly, by a well-known measure of irrational trading known as the “disposition effect”, the Indian investors appear to be significantly more irrational then the other investor groups.