Vijay Kumar Gaba

One of the most popular concept of invetsing is the "power of compounding". Almost every prominent investor and financial author has emphasized on this concept.

The principal of compounding, insofar as financial investments are concerned, works on the basis of three key factors (a) regular investment; (b) staying invested for long period; and (c) rate of compunding. To take full advantage of the power of compounding, it is therefore essential to:

(i)    Invest regularly;

(ii)   Reinvest the return on investment; and

(iii)  Try investing at the maximum possible rate of return, without of course compromising the safety requirements.

Does this imply that the concept of compunding is relevant only for investors who could "buy and hold" an investment for sufficiently long period of time?

This question is more pertinent to answer is whether the concept of compounding is relevant for stock traders also; especially when currently the markets are being dominated by the "Robinhoods" - the individuals indulging in short term (mostly daily) trading in stocks.

I beleive that compunding does work for the day traders and short term traders also. In fact it works more hard for them as it impacts them on both the sides, i.e., in gains and in losses. For example, consider the following:

(a)   If you buy a tocks Rs100 on Monday and it rises 10% on Tuesday, the gain is rs10 and the closing value would be Rs110. If the stock rises 10% again on Wednesday, the gain would be Rs11 (10% of Rs110) not Rs10. And so on.

(b)   If a trader buys a stock on Monday at Rs100, and it rises by 10% on Tuesday, the gain is Rs10. However, if it falls 10% on Wednesday, the loss will be Rs11 and not Rs10.

(c)    If a traders buys a stock at Rs100 and it falls by 25%, the value of the stocks wouild be Rs75. It would now need 33% gain in stock price for the trader to recover his cost. If the fall is 50%, the gain required to break even would be 100%.

If you find it too simple and nothing much to bother about, add the transaction cost to these examples. In case of traders, the transaction cost of aposition compunds witrh every trade. This is the most ruthless element of the entire trading process. It does not care if the trader is making or losing money. It just keeps gnawing on the capital of the trader with each trade he executes. To under stand the magnitude of this consider this example.

A trader pays 0.2% for a delivery settled trade. The total transaction cost, including l;evies and other charges would come to appx 0.4% in his case. If he rotates his position five time in a month, assuming there is no net change in the price of stock he would have paid 4% as transaction cost only, i.e., massive 48% per annum. If he repaets this feat for one full year, he woould have lost 48% of capital in transcation cost only.

The case would be worst, if he is trading by using margin financing. The cost of margin financing (ranges efectively between 12% -30%) also keeps compounding each day. In many cases the etire capital of traders gets eroded just by transaction cost and margin interest.

It does not stop here. There is another devil eyeing the capital of the trader. If the trader sticks to a losing position for over one yyear and then switches to another "rocket", which would give enough return to make for the losses of the dud, the finance minister may not spare you. The losses of "dud" in this case would be long term and gains of "Rocket" would be short term. The trader will end up paying 15% tax on these gains!

Continuing from yesterday (see De-institutionalization of household savings)

It is important to note that investors moving away from passive investing to active investing is not an India specific phenomenon; rather it is a global shift. For example, there is massive outflow of funds from equity mutual funds in US, while benchmark indices have been scaling new highs. This outflow of funds has coincided with the tremendous rise in "Robinhood" investors - people buying and selling stocks directly on discount brokerage platforms.

As Sanjay Satapahty, a fund manager at Ampersand Capital, highlights "Trend of ETF was a megatrend over last decade and the reversal can have huge implications." (see here)

In past five months we have seen some glimpses of the likely implications for the market, should the shift from passive investing to active investing sustains over a longer period. Since the market bottom in March 2020, the small cap stocks (+73%) have outperformed the benchmark (+51%) and Midcap (+57%) significantly. The sharp small cap outperformance in June and July has coincided with the net outflows in equity mutual funds since middle of June 2020.

This outperformance has come on the back of massive rise in market volumes in value terms; number of daily trades; quantity of shares traded daily; and positive market breadth. It is also important to note that this has happened with no major change in implied volatility, much stricter margining norms and no significant rise in leverage.

I find that the following factors behind these trends-

(a)   Dismal performance of asset managers (mutual funds as well as PMS). Most fund managers have disappointed the investors who were given high hopes through aggressive "Mutual Fund Sahi Hai" campaign. There have been many instances of impropriety and unethical practices, especially in case of PMS. This might have led the investors to take the things in their own hand.

(b)   The socio-economic lock down due to outbreak of COVID-19 has rendered many people jobless. Besides many businesses have been working at zero or sub optimal capacity reducing the working capital requirement materially. Many of the jobless individuals and idle businessmen with cash may have started trading in equities in order to generate some income.

(c)    Many young professionals who have been told to work from home, may have found spare time, which they are utilizing in trading in stocks. (For more details see "Rise of Retail Investor")

My primary view has been that this trend of "Robinhood investing" may not sustain as it prevails presently. Nonetheless, we may see the following corrections in the markets over next one year or so:

(a)   The top heavy indices may inspire changes in the methodology of stock market index construction. Till then-

(i)    The diversified funds may take precedence over ETFs based on benchmark indices.

(ii)   Index heavyweights may either stagnate or see correction in prices and broader markets may remain more active.

(b)   The compensation and performance evaluation rules for professional asset managers may see material changes to make them more accountable

(c)    As the economic activity picks up from 2021, the part time investors and traders may return to their jobs. Also, the spare working capital of partially operative businesses may also flow back to routine business. This should mark the beginning of the decline of Robinhood investing.

Tomorrow I shall share my technical view on the Indian equity markets.