Most retail investors are not enjoying this HRITHIK dance since HRITHIK is conspicuous by its absence in their portfolios
The financial theory assumes the investor as a rational wealth maximiser. The rational investor takes decisions based on fundamentals and financial reasoning. But, in reality, the investor is far from rational; he/she is often guided by emotions far removed from financial logic.
This is the reason why markets often become manic-depressive, driven by greed and fear. This emotional reaction of investors manifests more in retail investor behaviour.
Retail investors are unduly influenced by herd instinct, and therefore, they move with the crowd even when the crowd-behaviour becomes irrational.
Herd behaviour is the wrong investment strategy:
A significant trend in retail investor behaviour is aggressive buying when the market is bullish. When the market sets new records and stories of investors making fortunes become attention-grabbing news, retail investors jump in and invest indiscriminately, often in low-grade stocks.
Then the inevitable crash happens and poor quality mid-and small-caps get slaughtered. In the market crash, blue chips would have become very attractive, warranting selective buying.
But, retail investors sell everything at huge losses and flee in panic, only to return at the height of the next bull market.
Successful investors are mostly contrarians. They buy when the crowd sells, and sell when the crowd resorts to irrational buying.
Only a minority of retail investors moves away from the herd. Majority swims with the current and gets lost. The mid- and small-cap frenzy of 2017 was a classic manifestation of this irrational herd instinct.
The HRITHIK dance:
Nifty has hit record high. Market commentators are now describing the resilience of the Nifty as HRITHIK dance. HRITHIK stands for the seven blue chips – HDFC Bank, Reliance Industries, Infosys, TCS, HDFC, ITC and Kotak Mahindra Bank. Presently these 7 stocks account for 47.5 percent weightage in Nifty.
If we add ICICI Bank to this list the weightage would be 52.8 percent. Nifty’s impressive performance is due to the strength of these stocks.
Most retail investors are not enjoying this HRITHIK dance since HRITHIK is conspicuous by its absence in their portfolios.
The logic behind the HRITHIK dance is simple. These are high-quality stocks with clear earnings visibility. The net profit of these companies in FY20 is almost predictable and major divergences would be remote.
But in the case of most mid and smallcaps, this predictability is difficult and the divergence between the expected and the actual can be huge. Consequently, the share prices would react—both positively and negatively—depending on the outcome.
A big mistake retail investors make is to extrapolate the earnings of mid and smallcaps into the future. This can prove horribly wrong. Particularly, in an economic down cycle, mid and smallcaps will find the going tough.
Consistent irrational behaviour of some retail investors is to ‘average down’. Averaging down is tempting since you are getting the stock at a lower price than your original price.
But, averaging down will be successful only in the case of quality companies undergoing temporary stress. If the downtrend in price is caused by structural factors impacting the business model, averaging down will be tantamount to catching falling knives.
In 2018, many small-cap stocks crashed by more than 50 percent, some even more than 70 percent. Many of them—HCC, Reliance Naval, Reliance Communications, Monnet Ispat, Ruchi Soya, Manpasand Beverages—were crashing due to structural problems, serious corporate governance issues, auditor exits, etc.
During these crashes, mutual funds, which had invested in these stocks, exited. But the retail investors steadily increased their stake in these low-grade stocks.
Stepping in tune with the HRITHIK dance would have been the smart investment strategy; but unfortunately, retail investors were busy catching falling knives. To be successful, retail investors have to change their investment strategy.
The author is Chief Investment Strategist at Geojit Financial Services.
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