Vijay Kumar Gaba

A random walk through the settlement statistic of NSE for past two decade and half decades provided some interesting insights into the market evolution over past two decades. It is interesting to note the things that have changed and the things that have not. Regardless, it is comforting to note that Indian markets are maturing well and the systemic risk appears to have subsided materially. The best part was to observe that our markets have become more democratic with deeper and wider participation.

(All data is sourced from www.nseindia.com)

Indian market maturing well

The latest bull market has shown that the Indian investors and traders are maturing very well. The tendency to recklessly over trade that was witnessed during dotcom bubble, and to some lesser extent during credit bubble of 2007-08, seems to have been reigned well now.

To give it some perspective, at the peak of the dotcom bubble, the average daily turnover of NSE was close to 0.8% of the total market capitalization in FY01. In FY08-FY09 it remained in the range of 0.3-0.4% of the total market cap. However, in the latest bull market, it peaked close to 0.3% in FY20-FY21.

In fact FY21 average daily turnover (ADT) as percentage of market cap has seen marginal decline over FY20, despite a 60% rise in the value of ADT.

Definitely, the changes in ownership pattern of Indian equity may have been at play in this. The institutional and promoter ownership is now much higher as compared to FY01. Nonetheless, there are clear signs of sensibility in day trading patterns, as depicted by the tremendous rise in the option volumes in past 10years. The traders now definitely prefer options more than the stocks, where they can better control their exposure in accordance with their risk tolerance.

A reliable evidence of the rationalization of speculative tendencies over past 20years is available in the form of lower interest in low value (penny) stocks.

In FY01, at peak of the dotcom bubble, in value terms only 8.4% of the traded value resulted into delivery of shares, while 91.6% value was intraday trading. Moreover, when we see the total number of shares traded resulting in delivery, it was 16.5%. This implies that traders were not only overtrading, they were trading more in low priced (penny) stocks.

The share of delivery in the value of trades increased to 27.6% in FY08, and this time the almost 25% of shares traded resulted in delivery; implying that the trading in penny stocks was much lower in FY08.

In FY21, the percentage of delivery has reduced materially to ~17% both in terms of value trade and number of shares traded; implying that traders continue to be cautious about penny stocks and focusing more on mid and large cap stocks for taking delivery.

Another evidence of market maturity comes from the share of smaller companies in the overall market activity.

In FY01, at the peak of dotcom bubble, numerous small, hitherto unknown and often unsustainable businesses were the top traded shares on the stock exchanges. In top 10 most active securities, 7 had market cap of 1% or less of the total market cap of NSE, with 4 having a market cap that was less than 0.1% of the total market cap.

In that year, on NSE the top 10 most active securities accounted for an insane 73% of the total traded value; whereas these securities accounted for just 13% of the total market cap. Himachal Futuristic (HFCL) with just 0.17% of the total market cap was the most active security accounting for over 15% of the total market turnover. Two other small cap companies Global Telesystem (0.11% of total market cap) and DSQ Software (0.05% of total market cap) accounted for 9% and 6.5% of total turnover respectively. To put this in perspective, the company with the largest market cap (Reliance Industries, 6.25% of total market cap) accounted for just 4% of the total turnover; and IT bellwether Infosys with 4.1% of total market cap, accounted for 8.1% of the total market turnover.

In FY08 also, 4 companies accounting for less than 1% of total market cap of NSE figured in the top 10 most active securities. The 6 top most active securities were Reliance group companies. But, the top 10 most active securities accounted for just 27% of the total turnover. Reliance Industries with 6.8% of total market cap contributed just 5% to the total turnover. IFCI was the only microcap stock in top 10 most active securities list.

Things improved significantly in FY20, when top 10 most active securities accounted for 20% of the market cap and 26% of the total turnover. Though this year also 4 companies with less than 1% of the total market cap figured in the list, the skew of share in total turnover was much smoother. Reliance Industries was again the top traded stock, but now accounting for just 3.6% of total turnover.

 

Systemic risks lower now

The stricter compliance norms, improved surveillance and disclosure practice and wisdom gained through hindsight have resulted in materially lower systemic risks in the markets.

Though the common man had started to participate in the stock markets from early 1990s as the economy was opened up, the development of Information Technology industry in late 1990s provided the real impetus. A large number of IT workers came from middle and lower middle strata of the society and had an opportunity to work in global companies. Young professionals from the smaller towns migrated to metropolis and foreign countries. ESOPs became popular and that laid foundation for a deeper and wider participation in the stock markets. The understanding about the financial investments however did not grew in tandem with the understanding of complex IT algorithms.

Besides, a large number of new entities, dealing in new economy businesses and services, came into existence. Many of these companies did not survive the test of solvency for long. Consequently, about one third of the companies listed on NSE in March 2000 had vanished by March 2004.

This was not repeated in 2008-09 and 2020 market crashes. The number of companies available for trading on NSE increased by 25% during the period from March 2007 to March 2010. During the period between March 2020 and March 2021 also the number of companies available for trading has increased by 1.5%.

Democratization of Indian markets

A key development in the stock market has been the democratization of the markets. Not long ago in the history of Indian stock market, the market participants were a small privileged group of people, mostly from established industrial families or senior corporate executives.

Common household investors had begun meaningful investment in listed equity in late 70’s at the time of forced dilution of foreign owned companies operating in India, under the provisions of a stricter Foreign Exchange Regulation Act (FERA). These companies now known as MNCs were then referred to as FERA companies in common market parlance.

Reliance in 80’s and PSU disinvestment and capital market reforms in early 90’s drew the 2^nd lot of household investors. IT boom of late 90’s drew the 3^rd and the largest set of new investors to the listed equity. However, the participants were mostly concentrated in the few larger cities of some industrialized states. The four top cities accounted for more than 80% of investment amount and investors.

Anecdotal evidence point to the fact that Covid19 enforced lockdown has drawn the latest set of investors to the equity markets. 2020 was the period when many businesses were either locked down or their workers were operating from home, whereas equity markets were functioning uninterrupted. This was one trading business that could be done from the comfort of homes and without any additional investment in infrastructure or facility building.

Since, traders and small business owner had no work to do; and bank deposit and bond returns were falling; many of them deployed their working capital in the equity trading. Many small and micro businesses which were declining since demonetization and GST implementation also shut down during this period, with their owner shifting their focus on financial investments.

Thanks to the significantly improved accessibility due to the financial inclusion efforts, technology and Fintech popularity, the participation in stock market is now much deeper and wider. People from across the country and wider spectrum of socio-economic background are participating in the equity investing.

One glimpse of this democratization process could be seen from the average trade size on the stock exchanges. In mid 1990s the average trade size on NSE was in excess of Rs1,00,000. This fell below Rs20,000 by FY12. In FY21 it has increased to above Rs 33,000, (higher than the past five year average of Rs26,000), but has again declined to around Rs29000 in past couple of months.

In a market with total market cap of Rs250trn, where the delivery percentage is just 17% of the total value and number of share traded on daily basis, an average trade size of Rs29000 is a stronger indication of democratization of market than the number of trading & depository accounts opened or mutual fund portfolios created.

 If we consider the sector wise performance since April 2020, there exists huge disparity between various sectors. While Metals and IT have remained massive outperformers; the consumer (FMCG & media) and PSU Banks have been lagging far behind. Auto, Services, Pharma, and Infrastructure have performed mostly in line with the benchmark Nifty.

Pharma and Infrastructure performance is little surprising as both the sectors had major catalysts in Covid19 and massive government spending on infra building to stimulate the sagging economy.

But what is most surprising is the lack of investors’ interest in PSU banks. Notwithstanding, numerous research upgrades of SBI; government beginning the process of disinvestment in couple of PSBs; improved profitability shown by all the PSBs in FY21; and a market heavyweight buying material stake into Canara Bank; and many private sector lenders faring much worse than their Public sector peers - PSU Banks have failed to impress the traders and investors alike. We may attribute this underperformance to a number of factors, e.g., huge losses suffered by investors who invested in these banks in past 4-5years; material equity dilution to bridge the capital inadequacy gap; uncertainty about how the Covid19 related stress will reflect in bank books etc.

Impact of Covid19 pandemic on consumers’ income and consumption behaviour might have impacted the sentiment towards the consumption sector. The displacement of a large number of workers due to pandemic may also have been a factor impacting the consumption. Notwithstanding the huge stimulus to support the household consumption, the consumption growth has been lower than the estimates. Of course expensive valuation due to outperformance of stocks in previous years may also be one of the factors.

The question now is – “Do we have enough catalysts present to cause a major sectoral rotation in the markets?”

Will a weaker USD, sharp outperformance, and expensive valuations result in traders and investors moderating their preference for IT sector?

Will supply augmentation due to easing logistic constraint, and demand tapering due to inexorbitant commodity prices, result in softening of commodity prices and therefore traders rotating out of metal stocks?

Will the well managed fiscal conditions, reasonable valuations, improved earnings and growth visibility and an earnest beginning to implement the National Asset Monetization Plan, spur interest in infrastructure sector?

We would know the answers to these questions in due course; nonetheless it is not a bad idea to be alert and keep a close watch

 Historic performance of a banker

In the summer of 2007, at the peak of sub-prime bubble, a top executive at a global bank presented to the Board that the bank has expanded its footprints to 11 new frontier markets and materially augmented the operations in the 13 emerging markets by enhancing the workforce by 19% in the past one year, a record in the 90year history of the bank. The board applauded the presentation and approved the 100% hike in the annual bonus for the top executive.

In the spring of 2009, the same manager made another enthusiastic presentation to the management. He said, “the management has been able to cut the cost by a whopping 28% to meet the challenges of global financial crisis. We have optimized our operations by exiting the non-profitable operations in 17 frontier market and 2 merging markets, and materially curtailing the operations in 9 emerging markets, to achieve 20% cut in the total workforce in the past one year; a record in the 92years history of the bank. The board applauded the gigantic effort of the management and approved a modest 35% increase in the bonus of the top executive.

Super Heroes and the Super power

The President of the United States, Joseph Robinette Biden Jr., defended the decision to withdraw forces from Afghanistan after 20 years of conflict. He described the decision as “the best and the right decision for America which ended an era of major military deployments to rebuild other countries.” In his address to the nation on Tuesday, Biden said, “there was no reason to continue in a war that was no longer in the service of the vital national interest of the American people.” He further assured is people by saying, “I give you my word: With all of my heart, I believe this is the right decision, a wise decision, and the best decision for America, he said.”

When the US decided to send the troops on ground in Afghanistan in the wake of the attack on World trade Center in New York (9 September 2011), the then president George Bush has commented, "The attack took place on American soil, but it was an attack on the heart and soul of the civilized world. And the world has come together to fight a new and different war, the first, and we hope the only one, of the 21st century. A war against all those who seek to export terror, and a war against those governments that support or shelter them."

After 20years, the US government has ended the war by handing over the power to the same people who it was supposedly fighting for 20years.

However, both the decision to invade and quit have been described as historic and in the best interest of the people of United States.

Art of managing the denominators

“This is massive! India records a GDP growth of 21.1% in Q1 o FY21-22”, exclaimed a leader of the ruling party.

One of the key economic advisors of the government emphasized that “the GDP data for the first quarter reaffirms the government's prediction of an imminent V-shaped recovery made last year.”

“It's a big economic comeback. Q1 GDP of 2021-22 grows by a phenomenal 20.1% as per provisional estimates”, a senior union cabinet minister exuded ebullience.

Similar sentiments were expressed by most office bearers and prominent supporters of the ruling party, advisors to the government and members of the union cabinet.

On the other hand, the members of opposition parties, their supporters and some outside experts were not too impressed with the apparently high growth number.

A prominent left party leader rejected the claims of the government by highlighting that “Compared to 2 years ago, India’s GDP shrinks -9.2%.”

A Congress spokesman clarified that “India's GDP for April to June 2021-22 (Rs32.38trn) is lower than India's GDP for April to June 2019-20 (Rs35.85trn) and very close to India's GDP for April to June 2017-18.”

A former senior economic advisor to the government who is presently a senior official with IMF, rejected the GDP as a shocking bad news. He commented, “It needs just a little arithmetic to see that India's Apr-Jun 2021 growth of 20.1% is shocking bad news. The 20.1% is in comparison to Apr-Jun 2020 when India's GDP had fallen by 24.4%. This means compared to GDP in Apr-Jun 2019 (i.e. 2 years ago) India has had a negative growth of -9.2%.”

The politicians these days have mastered the art of managing the denominator. They set a weak denominator to exaggerate your status and performance. Most governments have, for example, moved the denominator to “pre Covid” levels to make exaggerated claims of their status and performances. Not many people are bothering to note that “pre Covid” conditions were pretty bad in itself and reaching there by making a V shaped recovery may not be a great feat in itself. Though it certainly provides comfort that we did not deteriorate much due to covid.

Insofar as the common people are concerned, they would be better off ignoring these manipulated narratives and focusing on the per capita real growth in GDP and change in the Gini coefficient that measures the scale of economic inequality in the country.

The real GDP growth in percentage terms will have little meaning if the base or the denominator is very low (which is the case at present) or it is not adjusted for the population growth or the real household inflation. A 5% real GDP growth with 2% population growth would mean just 2.9% growth in per capita income. This is not likely to cause any material improvement in their lifestyle; especially when it is deflated by the headline inflation which may be very different that their actual household inflation. Also if the income inequality rises more with rise in GDP, it would mean that their income may not rise in tandem with the rise in average per capita income of the country.

 If a geologist tells you, “the Himalayan Glaciers are melting fast and there will be no water in the Ganges in year 2050”; what would be your instant reaction? Will you—

·         Rush to store water in buckets?

·         Begin to explore places which are not dependent on the Himalayan Rivers for their water needs, for relocation in next few years?

·         Commit yourself to the environment conservation by adopting 3R (Reduce, Reuse and Recycle) as part of your life so that the green house emission is reduced, global warming is reversed and the geologists are proven wrong?

·         Dismiss the information provided by the Geologist as fait accompli and get on with your routine life?

I may say with confidence that various people will react differently to this information, but none will rush to store water in buckets, and a very large majority will dismiss the information as fait accompli.

I believe that the finance and economics experts portending about various policy changes are no different than the Geologist forecasting end of the Himalayan glaciers; and the market’s reaction to their prophecies is also no different. A large majority of investors dismiss the experts’ views and perhaps no one takes material investment decisions based on these prophecies.

Nonetheless, these prophecies do create an environment of great anticipation with usual jitteriness and eagerness in the near term. One mistake that most of the common investor make in this environment of jitteriness and eagerness to do something, is to not ask themselves—

(a)   What is the situation that is being sought to change?

(b)   How the change would impact the businesses underlying their portfolio of investments?

(c)    How the action they are contemplating to take will protect them from the perceived adverse impact of the change in the status quo?

For example, take the case of experts’ prophecies regarding gradual termination (tapering) of the latest assets buying program of the US Federal Reserve (the Fed). For past few months, almost every finance and economics expert has spoken and/or written about the imminent decision of the Fed to taper its assets buying program and its likely impact on the markets. The markets have been witnessing intermittent bouts of volatility whenever any official of the Fed or a reputable expert speaks/writes about this change.

Jackson Hole is Davos in Wyoming

Last week the Fed Chairman Jerome Powell was scheduled to make a speech in a symposium held in Jackson Hole valley (Wyoming, USA). This annual symposium, sponsored by Federal Reserve of Kansas City, is being held since 1978; and in Jackson Hole since 1981. The symposium is usually held in the month of August, just ahead of the pre scheduled US Federal Reserve Open Market Committee (FOMC) meeting in September.

Many prominent central bankers, finance ministers, reputable academicians and market participants take part in this symposium to discuss the currently important issues facing the global economy. In distant past, some reputable economists, like James Tobin (Tobin Rule) and John Taylor (Taylor Rule), have presented their path breaking papers at the symposium.

It is customary for the US Fed representative (Usually the Chairman or a senior official) to present their thoughts on the topic selected for that year’s symposium. The topic for 2021 symposium was “Macroeconomic Policy in an Uneven Economy”.

There has been couple of instances (Paul Walker 1982 and Greenspan 1989) where the US Fed representatives dropped some hints about the imminent policy changes in the ensuing FOMC meetings. But those hints were incidental and not by design. Otherwise, there has been no instance where the thoughts of the US Fed representatives have actually digressed from the given topic for the symposium. Nonetheless, various experts have been regularly conducting a post-mortem of their speech to find mentions of the words and terms which they can use to market their views in the garb of the Fed’s hints.

In fact in past two decades, no path breaking paper has been presented at the symposium and Fed chairman speeches have been noted for all the wrong reasons; most notable being the Bernanke dismissal of sub-prime crisis (2007); and Greenspan’s advocacy for expansionary policies (2005), which was heavily criticised by Raghuram Rajan in 2005 and rest of the world in 2008.

It would therefore be not completely wrong to say that Jackson Hole event is now mostly irrelevant for the financial markets. A harsher criticism would be to state that Jackson Hole is on the path to become American version of annual event held by an NGO (World Economic Forum) in Europe’s Davos.

For records, at this year Jackson Hole symposium, the Fed Chairman did not say or hint anything that had not been said at previous FOMC meetings, Congressional testimonies and various public speeches. The focus was on the topic of the symposium rather than the monetary policy of US Federal Reserve. Mr. Powell just reiterated, “The Committee (FOMC) remains steadfast in our oft-expressed commitment to support the economy for as long as is needed to achieve a full recovery. The changes we made last year to our Statement on Longer-Run Goals and Monetary Policy Strategy are well suited to address today's challenges.”

If you were also bothered about the taper signaling at Jackson Hole, the Fed Chairman actually hinted that they have taken lessons from the past instances of Fed trying to stay ahead of the curve and hurting the markets. Mr. Powell said, “The period from 1950 through the early 1980s provides two important lessons for managing the risks and uncertainties we face today. The early days of stabilization policy in the 1950s taught monetary policymakers not to attempt to offset what are likely to be temporary fluctuations in inflation.¹⁵ Indeed, responding may do more harm than good, particularly in an era where policy rates are much closer to the effective lower bound even in good times.”

So where do you see the scope of any action by the mighty US Federal Reserve, that would even marginally harm the investors’ interests!

Dealing with Taper Tantrums

Now coming to the Taper tantrums, it is important to understand the implications of the Fed’s assets buying program; simply because the impact of the tapering will entirely depend on these.

Fed’s Large Scale Asset Purchase Program (QE)

The Fed started a Large Scale Asset Purchase Program on 25^th November 2008 (QE1) to “manage the supply of bank reserves to maintain conditions consistent with the federal funds target rate set by the FOMC”. The idea was to provide enough liquidity support to stabilize the financial system and stimulate faster growth. The program was executed by increasing money supply (Quantitative Easing or QE) through purchase $175 billion in agency debt, $1.25 trillion in agency MBS, and $300 billion in longer-term Treasury securities. It was also decided to reinvestment the principal amount received on maturity of the securities purchased under the program.

The Second Round of the Program was started on 3^rd November 2010 (QE2) to purchase $600 billion in longer-term Treasury securities.

The Third Round of the program (QE3) was started on 13^th September 2012 and included a total purchase of $790 billion in Treasury securities and $823 billion in agency MBS during September 2012 and October 2014.

Overall, close to US$4trn were added to bank reserves during 2008-2014 under the three rounds of Asset Purchase Program by the US Federal Reserve. Besides, these purchases, the Fed also implemented Operation Twist under which it managed to extend maturity of over US$660bn US government securities.

On 16^th December 2015, the FOMC noted that the conditions set for normalization of monetary policy have been achieved, and process of normalization of target rate could now begin. The actual normalization process started in October 2017 when the Fed “decreased the reinvestments of principal payments from the Federal Reserve’s securities holdings”.

The tapering of first three rounds of QE did not entail any Sale of securities by the Federal Reserve. It just implied that the Federal Reserve will not reinvest the amount received in maturity of the securities purchased under the program. The maturities may happen over a period of up to 25yrs.

Consequently, the assets on the Fed’s balance sheet decreased from the peak of US$4.5trn in winter of 2014 to US$3.8trn in the summer of 2019.

To support the economy in the wake of lockdown imposed to mitigate the impact of Covid-19 pandemic, the fed started the latest round of its Asset Purchase Program (QE4), as the Fed cut back its target rate back lower. QE4 has resulted in the Fed’s balance sheet ballooning to over US$8trn, a rise of over 100% in less than 2yrs time.

Presently, the fed is buying US$120bn worth of securities every month from market.

Five things to note from this—

(a)   The US Federal Reserve’s asset purchase program aims to achieve the FOMC’s target rate, implying that the assets are purchased by Fed to keep rates lower by supplying adequate liquidity to banks.

(b)   Tapering does not mean immediate sale of securities held by the Fed. It just means not buying more and/or refraining from reinvesting the maturities as and when these occur.

(c)    If US$120bn/monthly purchases are decreased by US$20/month, it would still mean that Fed will still be adding US$300bn more to its balance sheet in next 6months.

(d)   Fed balance sheet had started to increase in November 2019, even before the pandemic forced worldwide lockdown. If the circumstances need, the Fed shall again restore its QE program, like in 2020.

(e)    US Fed is not the only Central Banker in world which is running a QE program. European Central bank (ECB), Bank of England (BoE), and Bank of Japan (BoJ) are also running major QE programs.

QE is win-win for the Fed and US economy

The cost of funds for the Fed is zero. So when Fed buys interest bearing securities from the market and infuses more liquidity in the system, five things happen –

(i)    Fed is able to earn substantial income on the securities so purchased;

(ii)   The interest rates in the economy are pegged lower, thus helping the government to finance its fiscal deficit at lower cost;

(iii)  Fed repatriates its income surplus to the Federal government by way of dividends, which also helps reducing the fiscal deficit;

(iv)   The additional liquidity supplied by the Fed helps to stabilize the financial system and supports the economic growth; and

(v)    QE keeps the USD from strengthening and thus helps the trade account of US.

It is thus a win-win arrangement for the Fed and US economy. There is no reason to believe that QE will be completely terminated without significant improvement in the US economy or an even more attractive alternative to QE emerging.

QE is not same as Fiscal easing

Quantitative Easing (QE) must be understood different from the fiscal easing. In case of fiscal easing the government borrows money from the market and hands out immediate benefits to the people and businesses in the form of tax cuts, subsidies, incentives and cash payouts; whereas in case of quantitative easing, the central bank provides reserves to the commercial bankers so that they can meet the increased credit demand, without pressurizing the lending rates. The decision to lend or not to lend, and decide the actual lending rate remains with the banks.

QE and Bank Credit are poorly correlated

From 2008 to 2014 almost every penny of QE was getting accumulated in banks’ excess reserves (liquidity with banks that can be given as loan). It was only in 2016 (after taper tantrum started) that banks started to grow their loan books by running down on reserves. The excess reserves have again increased sharply in 2021 to an all-time high of over US$4trn.

The argument that the tapering will suck out liquidity from the system therefore does not appear to be fully supported. It is true that the mortgage rates had risen from 3.5% in 2016 to ~5% in early 2019. However, correlating this fully with the tapering may not be justifiable. This period saw sharp rise in economic growth, asset prices and therefore credit demand. Besides, the rates had started falling from mid-2019 when growth started faltering, much before the pandemic and QE4 started. 

QE and Indian investors

Insofar as India is concerned, there is little evidence to highlight any strong correlation between QE and foreign flows, market performance and economic growth.

In past 20 months the US Fed has done over US$4trn in QE. However, the Indian secondary markets have received a paltry US$9.7bn in net FPI inflows. The net FPI inflows since 2010 have been less than US$35bn against QE amount of US$8.3trn. Five out of past 12 years have witnessed negative FPI inflows. Nifty returns have shown very poor correlation to net FPI flows in a particular year; even though on day to day basis, a stronger correlation might exist.

Besides, India’s external position is much stronger as compared to 2013-16 taper tantrum period. The present situation of the current accont balance, short term foreign currency debt and forex cover is substantially better than the 2013-2016 position.

What to do? – Do not fill your buckets for now!

The question now is “what a common Indian investor do when the Fed actually announces a tapering by the end of 2021, as widely expected, or refrains from doing so?”

In my view, the answer is “Nothing”.

The common investors must note that QE of 10yrs may not have played any direct role in construction and performance of their respective investment portfolios. They must also keep faith in the collective wisdom gained by of the central bankers of the world since the global financial crisis; and believe that they would not do nothing to harm the still fragile global economy, weak in the knees markets and governments with explicit socialist agendas.

Therefore, it would be prudent to not take any investment action merely because of quantum of QE done or not done by the Fed. (No water storage in buckets)

An action on the investment portfolio would be needed only if any pertinent change is witnessed in the prospects of the underlying businesses. (Look for businesses that are likely to grow regardless of central banks’ actions)

As a prudent policy they should maintain a balance between Safety, Liquidity and Returns (SLR) factors in their respective portfolios. (Own businesses that will survive the volatility; hold sufficient liquidity for the transition phase; invest in businesses that promise sustainable higher return)

Our Children must be given strong reasons to believe that if central Asian and European invaders did not plundered us, we could have created much better roads, railways, ports, monuments and social infrastructure what they created to further their objectives of plunder, oppression and exploitations. 

The benchmark equity indices in many global markets are presently positioned close to their all-time high levels. The equity shares of new age companies, with relatively untested business models, are commanding prices, which could be termed “obnoxious” from the view point of conventional valuation methods. The global debt yields are staying obdurately low, despite higher inflationary expectations and liquidity contraction talks. The market value of cryptocurrencies, one of the youngest asset classes, is also more than US$2trn.

In these circumstances, “Risk” is naturally the most talked about, and understandably the most ignored, term in the financial markets. All market experts are highlighting the urgent need to manage “Risk” for investors.

Investors’ survey on understanding of Risk

A quick survey of household investors’ perception about the “Risk”, and their methods of managing “Risk”, however highlights that “Risk” may actually be one of the least understood, though most talked about, terms amongst these investors. A significant number of such investors appear to be carrying serious misconceptions about the risks involved in investing activities, especially equity investing.

The following observations from the survey are particularly noteworthy.

Buying Options is perceived least risky

“I take calculated risk in the market. I only buy options. The loss in options is limited while the gains are unlimited.”

This is the most noteworthy comment from the survey. This implies that people may be buying naked options, fully knowing that they can lose 100% of their principal amount, if the option expires out of money by the end of week/month. They are “investing” in equities, just the way they would buy a lottery ticket – risking 100% of their capital if the final outcome does not match their wager; sincerely believing that they are taking “minimal risk”.

Volatility of markets is perceived as the most important risk

The most seasoned participant in the Survey commented, “I invest only in quality companies. There is no risk in such investments. The only risk is market price volatility, which I can easily take since I invest for long term”.

Almost every respondent in the Survey believed that volatility in the market price of shares and market manipulation are the most important risks in equity investments. A significant proportion of the respondent believed that volatility is the only risk, and they do not mind taking it.

A deeper probe however indicated that a large majority of investors associate the “quality of business” with the returns they have personally made in the particular stock. Reliance Industry Limited and ITC were the two stocks that attracted divergent opinions. It appears equal number of people find these two stocks “poor” and “good” quality, depending upon when they bought it and what have been their returns from these. Many respondents cited some small and microcap companies as “good quality”, since they have made brilliant returns in these lesser known stocks.

Besides, the market volatility risk, market manipulation risk appears to be the most popular risk factor amongst investors. Most of the respondents sounded convinced that “operators” are able to manipulate the prices of stocks “at will”. Some of them even sounded skeptical, believing that the over regulation of market functioning is actually helping these “operators” in their activity. A significant proportion of investors strongly believed that the market volatility is staged by “operators” to deceive the gullible small investors, implying that market volatility is mostly an integral part of the market manipulation exercise of the unscrupulous elements.

Only a tiny percentage of respondents mentioned the business risk (company specific) as a major risk element in equity investing. About two third of the respondents were not aware that companies like Aban Offshore, Suzlon, JP Associates, Reliance Infrastructure, Reliance Capital, Reliance Communication, Jet Airways, OBC, SCI, Unitech, and BHEL etc. were part of the benchmark Nifty 50 index in 2007, and hence prima facie qualified to be included in “quality portfolios”. Most investment gurus and revered fund managers owned some of these names during 2007-2016.

Volatility may no longer be a “major risk”It is pertinent to note that the implied volatility (a measure of volatility used for derivative pricing) has persisted at low level in past one decade; though some occasional spikes were witnessed in 2013-14 and 2020.

An analysis of historical volatility (daily change in the Nifty 50 index) also supports this observation. In past 14yrs (since August 2007), there have been 154 daily moves of 3% or more in Nifty. Out of this 109 moves occurred during 2007-09; only 21 moves occurred in next 10years (2010-19) and 24 moves have occurred since March 2020 in the wake of pandemic. The number of large moves on both the directions has been almost the same. The risk of market volatility has obviously reduced materially in past one decade or so, primarily due to the stricter regulation and margining norms post global financial crisis.

Between the years 2008-2016 there were three major corrections in Nifty (25% or more). On each occasion, Nifty took more than 13months to recoup the losses incurred during correction. However, in past five years there has been only one draw down of more than 25%, and that too has been recouped in less than seven months.

…whereas the “business risk” may have spiked higher

On the other hand, increased global competition, accelerated technology evolution, and transformative regulatory changes, have led to tremendous rise in the business risk. More mid and large sized businesses face the risk of redundancy and obsolesce today, than ever. This risk was mostly associated with the smaller and weaker businesses in previous decades.

The pandemic has in fact enhanced the business risk in numerous businesses like transportation, hospitality etc. The commitment to climate change may itself threatened the sustainability of many businesses that rely on conventional fuels and technologies.

Diversification is best tool to manage risk

It is conventional wisdom that all eggs should not be put in one basket. In the principles of investing, diversification is used as a key risk management and return optimization tool.

One of the key observations of this Survey was the inadequate awareness of the participants regarding the concept of diversification. Most participants responded by saying that diversification means spreading the capital over a larger number of instruments, e.g., stocks, mutual fund schemes, etc. A diversified mutual fund scheme was invariably accepted as adequate portfolio diversification.

Buying units in five large cap diversified equity schemes of different mutual funds, having mostly identical portfolios will not achieve much diversification.

Risk tolerance

For example, take the example of the following three hypothetical investors:

Risk tolerance vs Age of Investor

Take example of these two investors:

Investor Mrs. Singh is 75yr old widow. She has 75% of her Networth invested in rent yielding good commercial properties. Both her children are well settled in life. She lives in her own house and enjoys good health.

Investor Mr. Rajan, is a 36yr old Investment Banker. He has good income, but uncertainties relating to his job are high. He suffers from diabetes and hypertension. He has home loan EMI, auto loan EMI, life insurance premium and health insurance premiums to pay regularly. He has a 3yr old child who needs to be admitted to a reputable school this year.

Obviously, the risk tolerance of Mrs. Singh is substantially higher than Mr. Rajan. But in reality, Mrs. Singh’s portfolio mainly comprises of bank deposits, debt mutual funds and FMCG & IT stocks that were purchased good 25-30yrs ago and have grown in value substantially; whereas Mr. Rajan regularly invests in small and midcap stocks with multibagger return potential (usually based on the tips he gets during the course of his work); and has an SIP in Nifty ETF (about 30% exposure to BFSI sector same as his employment).

Risk tolerance vs asset allocation

Investor Ms. Bansal has 67% of his Networth invested in stocks of her employer bank. She lives with her old and ailing parents in a joint family house. She pays EMI on car loan she took last year

Investor Mr. Mehta has 92% of his Networth invested in the equity of his own pharmaceutical business, which is well established and growing at decent pace. He gets very good salary and dividend from the company.

Asking Ms. Bansal and Mr. Mehta to make any further investment in equity may not be appropriate in the circumstances.

Asking Ms. Bansal to invest in debt funds with high exposure to financial sector would add material risk to her portfolio. Even making fixed deposits in the bank she works with would add material risk to her portfolio.

Mr. Mehta does not need any regular income. He already has 92% allocation to equity. A part of his balance Networth may best be parked in liquid assets that may be converted into cash immediately, should an emergency arise. The rest he can afford to invest - as angel investment, venture capital or private equity – in the healthcare ventures which he understands the best.

Risk does not mean probability of loss

For most investors, the risk is synonymous with the probability of loss. This in my view is a misconception, which primarily originates from the common tendency of not defining the investment objectives.

Focusing on only the safety of capital, usually distort the entire risk management process. A good risk management plan must address all the three dimensions of the investment objectives of an investor, viz., Safety, Liquidity and Returns (SLR).

Safety: The risk management plan must aim to minimize the probability of the loss of capital and/or returns.

Liquidity: The risk management plan must ensure the possibility of liquidating the portfolio assets at optimum cost and in minimum possible time.

Return:  The risk management plan must rationalize the return expectations of the investor, and ensure that expected returns are commensurate to the risk tolerance limits of the investor. Lower the tolerance, lower must be the return expectations.

Let me correlate this to the following very common and frequent investment advice one would read/listen on media.

This is indubitably a brilliant piece of advice. However, it may not suit every investor, for different investors invest with varying objectives and timeframes in mind. Besides, they may have different temperament and risk tolerance limits.

Investors who did not manage the liquidity risk well and were forced to sell at the bottom cycle, shall never be able recoup their losses.

Do note, half the bankruptcies across the globe may be occurring to failure in managing the liquidity risk.

Regulation of Risk

The market regulators are concerned with protecting the interests of the investors, orderly functioning of the markets and development of the markets. The objectives are achieved by a employing a variety of tools, e.g., ensuring full & fair disclosure of information to all market participants; prevention of unlawful and fraudulent activities in market; prevention of insider trading; creating reserves to limit the contagion effect of defaults; ensuring a efficient & secure clearing and settlement system; limiting excessive speculative activities; ensuring capital adequacy of the participants, etc.

It is critical to note that the Regulator is concerned with the systemic risks in the market only. They do not address any other risk that may be involved in the investing process. Some investors seem to be nurturing an illusion that it is the duty of the regulator to manage all the risk for them. They do not even mind holding the regulator accountable for the failure of businesses and market volatility.

Contrary to the popular perception, the job of the regulator is to augment the risk taking capabilities of the market participants rather than stifling the legitimate risk taking.

No flirting, just marry the Risk

“Risk hai toh ishq hai”, a famous dialogue from a popular TV series made on the life of infamous investor/trader of early 1990s, seems to have become anthem of many young (and some not so young) investors in the equity market. These investors many a times are mistaking their gambling instinct with their risk tolerance. They flirt with equity stocks in the anticipation of getting some quick gratification; and not surprisingly, often end with substantial losses. These investors should rather spend some quality time understanding the risk in investing and marry the risk by imbibing it in their investment plan and strategy.