We find numerous theories around this one of the most discussed topic: Why Retail Investors always lose money. Retail Investors tend to follow the trend rather than the principles which govern the stock movements.
Many market studies often proved that, retail investors are the last few people to buy the stock or mutual fund. It is during the peak time, such stocks or mutual funds experience sell off pressure due to profit booking activities by professional investors.
The value of the investment now takes a hit and retail investors still cling on their investment in the hope of experiencing the peak again. The common nature of aversion for loss makes them sell their investments at the first sign of recovery. It is evident that retail investors incur loses only because of lack of discipline and lack of knowledge when it comes to investing.
When we are talking about lack of knowledge we are not even referring some high end mathematical models or stock picking strategies. Let’s just step back and revisit our high school math. The formula for compounded interest is:
Future Value = Present Value * (1 interest rate) ^ (number of years)
So if we want to increase the future value of our money the two governing factors are interest rate and number of years. So this brings forth the next question
“What is interest rate of our investments dependent on?”
Put in its simplest form: It is dependent on the type of Investments we make. So here comes our first hindrance: “Lack of Knowledge while picking the good funds”.
This is the most common problem for retail investors. They hear a couple of success stories around their friends and family about how they made a fortune in stock markets.
They start chasing the next multi bagger. They rely on market news and trends over fundamental research for picking the stocks. So by and large most of the mistakes by retail investors are committed because of lack of access to quality advice.
If we observe the compound interest calculation formula stated above, the second factor that governs the future value of investment is the number of years. The longer the time horizon the future value increases exponentially. 2^2 is 4 and 2^3 is 8.
Time horizon is in fact the second hindrance why retail investors lose money. They are so inclined towards profit booking that if they pick good funds, they sell it off as soon as they get good profits.
If they pick bad funds they hold onto them in the hope that the fund will perform better.
They hold on till it loses substantial amount and sell off. The other scenario where this time horizon plays a part is during the market recovery times. As and when they see an instance of market recovery, they start selling off their holdings.
The two factors, picking the good funds and holding on to them for longer period are interdependent.
It is important that retail investors opt for help in the form of quality advice to pick the investments. Once have a winner in your hand, holding on to it for longer time period to enjoy the benefits of compounding follows.
ArthaYantra is an integrated online personal finance company.