Beware of the bulls: Why you should enter this market with caution

After six years of acting like it was part of a snakes and ladder game, India’s stock markets are showing almost unidirectional movement. Every day gives a new hope to the market and after a long time large-cap, mid-cap and small-cap stocks are marching ahead. Some experts refer to this as a long term bull market while others are busy predicting market movement in the years to come. The exuberance, though not completely irrational, has replaced long term pessimism and caution that prevailed in the stock markets from early 2008 to early 2014.

When the market tumbled after the 2008 global recession, one group of investors who deserted it completely was retail investors. Once bitten always shy was the approach that retail investors adopted after the sharp fall in the market. While direct investments in equity just withered away, even equity mutual funds did not find favour with these investors with the pressure for redemptions increasing on mutual funds. Schemes like the Rajiv Gandhi Equity Savings Scheme could not bring too many new investors back to equity investments. In short, the stock market became the citadel of foreign investors and large domestic players.

Now with the market moving up again, is there a possibility that retail investors may knock on the door of stock markets again? The possibility is very high. The lure of quick money and myopic approach may bring these investors back once again. Indian retail investors have been victim of recency bias and have been found to be joining the race only when the market starts heating up or at least start moving up substantially. ‘Recency bias’ is the phenomenon in which a person remembers something that has happened recently, instead of recalling something that may have occurred a while back.

Retail investors become victims of the recency bias very easily. This happens because there is less of an investor and more of a trader in every retail investor. They want to make money quickly and look for opportunities where money can be made relatively easily. Many of them even buy penny stocks recommended by friends and small brokers. All principles of investing are set aside and the desire to make money in the shortest possible time starts dominating their thought process, something that is reinforced by a rising market.

The second aspect that makes retail investors gullible is their approach towards market timing. With limited skills, they want to time the market to make quick money. So they select stocks which will earn them a quick buck. In a stock market, timing is very critical but only for those who have extraordinary skill sets. For others, particularly for retail investors, it is the shortest route to hara-kiri. Naturally many retail investors fall victim to this and end up losing money.

Another aspect that has been attracting retail investors to the stock market is their bizarre interpretation of the law of demand. The famous law of demand says that ceteris paribus when the price of a good goes up, demand for it should fall, and vice versa. But strangely retail investors don’t believe in this, and demand stocks only when the price has gone up substantially. It’s something they have done many times in the past.

While a rising stock market in an opportunity for wealth creation for everybody, once again it needs to be understood that this is the place which requires long term investment. The stock market is not a place to make quick money and leave. It is place to wait and stay invested. For those who are risk averse or those who want to make quick money, stock market is not the place. Biases must be kept away while investing.