Why small investors never make money in the stock market

Dear Reader,

Take a look at the following chart. What does it tell you?


The above chart clearly shows that as the expectations of corporate performance have fallen, the amount of money coming into the equity mutual funds, the best representation of the small investor investing money in the stock market, has gone up. Stock prices are ultimately a reflection of the future expected earnings of companies.

What does this tell us? As analysts Saurabh Mukherjea, Gaurav Mehta, Prashant Mittal and Sumit Shekhar of Ambit write in a recent research note titled Exit The Fantasy, Enter The Reality: “The last time corporate India had such a poor performance in terms of revenue and profit growth was during the 2008 financial crisis, the year that had seen the Sensex drop by more than half of its peak.” 

So how has the stock market continued to do well (if we ignore the recent fall) despite the poor performance of Indian companies. The answer lies in the fact that small investors have been pouring in money into equity mutual funds, which in turn have been investing that money in the stock market.

In the last five months between April and August 2015, equity mutual funds have invested Rs 39,205 crore into the stock market. Between March and July 2015, investors have poured in Rs 45,127 crore into equity mutual funds. The foreign institutional investors, who have been driving the stock market for the last few years, have been net sellers and have sold stocks worth Rs 8,950 crore between April and August 2015.

As the Ambit analysts point out: “Today, however, in spite of such an abysmal performance, Indian equities have remained afloat, helped by retail investor optimism. In contrast, over the past six months, FII equity flows into India have dried up.”

In simple English what this tells us is that the small investors usually start investing in stocks around the time stock prices start to peak, with the expected corporate earnings falling. In fact there is research that backs this up.

As John Plenary writes in Capitalism—Money, Morals and Markets: “There is now academic evidence from Robin Greenwood and Andrei Shleifer at Harvard University that when markets are close to their peak, investors are most bullish because they tend to extrapolate recent rises in prices into the future when they form their expectations. In short, they expect the highest future returns when markets are close to a cyclical peak.”

This is precisely what seems to have happened with the small investors in India who started entering the stock market in hoards through equity mutual funds since mid-2014.

A similar trend was seen during the five month period of November 2007 and March 2008, when Rs 32,109 crore of fresh money came into equity mutual funds. During this time, the FIIs were net sellers to the tune of Rs 11,704 crore. In fact, the contrast comes out best during January 2008, when FIIs were net sellers to the tune of Rs 13,036 crore. At the same time equity mutual funds saw inflows of Rs 12,717 crore, and in turn they invested Rs 7,703 crore into the stock market. The BSE Sensex peaked on 8 January 2008, at 20,873.33 points. So, most money came into stocks when the Sensex was peaking. It started to fall after that and by 17 March 2008, the Sensex had fallen to 14,809.49 points.

A similar sort of trend is playing out now as well. In August 2015, the FIIs have net sold stocks worth Rs 16,877 crore. During the same period, the equity mutual funds invested Rs 10,017 crore in the stock market. The data for fresh inflows into equity mutual funds during August 2015 is not available as of now.

What all these numbers tell us very clearly is that the small investor ends up investing in the stock market through the mutual fund route around the time when the stock market is peaking. And this explains why the small investor rarely makes money in the stock market.

If the market continues to fall in the days to come, as it is expected to at this point of time, the mutual fund equity investor who has invested over the last one year, will be in for a rocky time.

Data contribution by Kishor Kadam.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek) 

The column was originally published on Firstpost on September 1, 2015