THE CATS AND THE MONKEY STORY

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Few days ago, some of my friends were arguing that stock is a zero sum game stating that you might make money on an occassion but you will also loose money on another occassion and as such people don't make money from the market. Recently, I also came across a topic in one of the orkut communites. The originator of the topic claimed that the retail players in the stock market basically end up with a loss. Few people admitted that their stock market endeavour was a failure while few said that they made good money in the market. I started my enquiry into the subject to ascertain why a lot of retail investors end up with a loss.

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Let me analyse it from the Indian context. Well, we all know that the market has performed really well in the last few years. However, let us take a realistic view of the market returns. Let us consider the ten year period between April 1,1996 and March 31, 2007. The performance of the nifty during the decade is shown below

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I don't know if there was some other time period that was as exciting as the last decade. As you can see in the chart, the first few years of the decade witnessed a relatively flat market. However, middle of the decade witnessed two major stock market bubbles. One was the Ketan Parekh scam and the other one being the dot com bust. The latter part of the decade saw sharp upturns followed by some correction at the fag end of the decade. I am fairly convinced that this decade fairly represents the general movements of a stock market and hence it is suitable to be used as a proxy for calculation of long term metrics.

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The decade started of at 968.30 and ended at 3821.55 resulting in a Compounded Annual Growth Rate (CAGR) of roughly around 15%. This CAGR of 15% is basically the geometric mean of the return on the Nifty. I don't have details about the dividend yield of the index during the period but I am sure that it can't be too significant. Taking cue from this past data and assuming an optimistic dividend yield of roughly 1%, the total return that could be expected from the market is around 16%.

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I don't have adequate data in hand. However, in general, organised fund houses tend to outperform the market and which means that the return that is available to a retail investor is even below this 16% mark.

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Let me now, introduce to you the biggest villain of the Indian stock market - 'Transaction Costs'. Well, transaction costs are highly inevitable in the world of business. There is always a gap between the seller and the buyer and you need a middleman and a vehicle to fill up this gap. The more underdeveloped the market is the higher is the transaction cost. In the Indian scenario, the transaction cost comprises basically of Brokerage, Security transaction tax and Other taxes such as service tax etc. You will soon realise why I called 'Transaction cost' a villain.

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Typically, large players like mutual funds or high networth individuals are subject to a very low level of brokerages. However, a typical retail investor in the Indian market pays not less than 0.35% (per leg) as brokerage for a transaction. Then you have a security transaction tax of 0.125% (per leg) besides a service tax on the brokerage fee. All this roughly converts to something around 0.5% of the value of a transaction. So, in case, if you are going to buy and sell a stock then you would eventually be shedding out roughly 1% of the entire transaction cycle. So, your return further gets eroded by 1% per transaction.

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Perhaps people wouldn't mind too much about incurring a flat 1% since the potential returns from the market far exceeds that of any other investment avenue. However, this is where a normal retail player committs blunder. Quite a lot of the retail players (atleast those who I know and including me) try to outsmart the rest of the crowd. In an endeavour to outsmart the market they keep switching stocks and every time one switches stocks he incurs the 1% transaction cost. Roughly 15 switches a year or roughly 5 switches every 4 months, by an investor erodes his share of the return from the market. If you are wondering whether people switch stocks so frequently, then perhaps you would be even more surprised to know that quite a lot of retail guys switch stocks even more frequently.

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Day trading is again another game where you probably have several loosers for every single winner. A typical day trader incurs atleast 0.2% (both the legs put together) of his trade value every day. So, in total a day trader incurs more than 50% (assuming 250 session per year) of his average investment as brokerage. This 50% is perhaps the total return of three guys. So, if he is going to make money beyond this 50% then definitely for every such winner there will be atleast four loosers.

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Besides you also have a crowd that tries to make money by using instruments such as the futures and options. While these derivative instruments represent one another exciting stock market instrument, it should be understood that they derive their value only based on the actual stocks that are traded. Hence the sum of the returns for the stock market and the equity derivatives market of all the players put together cannot exceed the total return of the stock market. However, derivative instrument also incur transaction cost.

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This is no different from the typical cat and monkey story that we read in our childhood - but perhaps a little modern. While the cats - the investors, fight between themselves to grab the bigger pie, the monkeys - the brokers (and the Government too), are calmly eating the cakes.

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Well, perhaps my intention was not to negatively portray the brokers. They play a very vital role in bringing the buyer and the seller together. But investors, out of their greed to outsmart their counterparts basically end up loosing all their profits to the brokers.

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I think perhaps, you would've realised by now as to why most of the retail investors end up loosing their money even in a market that is rewarding well. No doubt, there are people who make huge money despite switching stocks continuously. However for you to be that successful, you definitely need to be damn smart and have enough financial resources to drive the prices or the lady luck should be sitting on your lap. Again, as I mentioned above, for every such winner you are going to have several loosers.

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Before, I conclude, let me clarify one more thing. I am not saying that stock market doesn't reward. Neither I am saying that one shouldn't try to outsmart the market. But timing and continuous switching of stock is the not the best way to do that. If you want to outperform the market, then put your effort to see what others cannot see and identify that long term bet which will take you to the road of richness.