Saurabh Mukherjea says chasing the ‘lottery effect’ in small and midcaps can erode long-term returns

The note likened its low-risk investing style to cricketing discipline of avoiding the temptation of risky sixes that can lead to early dismissals, and instead focusing on accumulating steady runs.

Marcellus Investment Managers’ August newsletter, authored by founder Saurabh Mukherjea, has warned that India’s retail investors are increasingly falling prey to what it called the ‘lottery effect’ – or the tendency to chase high-risk, high-beta stocks with flashy narratives despite their historical underperformance.

This behavioural bias, the newsletter said, is helping drive frothy valuations in small and midcaps where retail participation is at record highs.

Backing its case with a 19-year study of the BSE 500, the newsletter showed that lower-beta stocks in India have consistently outperformed their higher-beta counterparts. Portfolios made up of riskier stocks have under-delivered both in average and compounded returns, underscoring the long-term validity of the so-called ‘low-risk anomaly’ in Indian equities.

The findings run counter to traditional finance theory that assumes higher risk should generate higher reward. Instead, volatile returns work against investors over time.

For instance, an investment alternating between annual gains and losses of 30 percent would post an average return of zero, but still erode nearly 40 percent of initial wealth over a decade due to the compounding effect of large drawdowns, the note said.

The anomaly was linked to structural features of Indian markets - retail investors’ preference for ‘lottery ticket’ stocks such as IPOs or distressed companies, and the leverage constraints faced by long-only mutual funds. With many unable to borrow, funds tend to tilt towards inherently riskier, high-beta stocks, pushing valuations further up and setting the stage for disappointing performance over the longer term.

The note likened its low-risk investing style to cricketing discipline of avoiding the temptation of risky sixes that can lead to early dismissals, and instead focusing on accumulating steady runs. For long-term investors, it argued, this approach offers a more reliable path to compounding wealth.

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