Are retail investors getting blinded by these ‘lottery effect’ stocks?

medium118763020Two interesting things are happening in the stock market currently. One, retail investors have become big buyers of stocks of large companies. Second, they are also the big losers as far as returns are concerned.In the past year, retail investors have been the big buyers of stocks that fell hard. At the same time, institutional investors were the big sellers who made money. The ET Prime Retail Index fell 18% during this period, while FPI was up 3%. For the same period, the Nifty has been down 3%.Are retail investors being blinded by the lottery effect? Are they overvaluing the chances of big gains, which normally leads to losses?Rise of retail investorsAs per NSE’s India Ownership Report of December 2024, individual investors’ ownership of the market rose. Direct non-promoter ownership in NSE-listed companies rose 20 basis points (bps) quarter-on-quarter (q-o-q) to a 70-quarter high of 9.8%, aligning with record investments of around ₹56,000 crore during the quarter. Their stake in the Nifty 500 increased 12bps q-o-q to 8.8%, while Nifty 50 holdings remained steady at 8%. Individuals, both directly and via mutual funds (MFs), now hold a record 18.2% of the market, surpassing FPI (foreign portfolio investor) ownership for the first time since 2006.“Our estimates indicate a ~₹30 lakh crore net accretion to household wealth in equities over the last two years, reaching ₹79.6 lakh crore,” the report stated.It is not that retail investors buy small- or mid-cap companies all the time. This time we see them buying Tata Motors, Jio Financial Services and L&T Finance. These companies have good pedigree and business models. There are chances that retail investors will make money.But consider this, shares of India’s largest passenger electric vehicle maker, Tata Motors, have corrected more than 48% from their highs of ₹1,179 last year. First in line to shed tears for the loss are retail investors — some 63 lakh of them — the highest number of individual shareholders in any Indian company.Some 7 lakh of these 63 lakh shareholders bought Tata Motors shares in the December quarter but the shares corrected 24% during the same time. In the past two months, the share price has corrected further. Some domestic auto analysts believe that a weak demand outlook and the impact of US tariff changes are yet to be completely priced in by the recent correction. But retail investors are still buying the dip.RBL Bank, which is suffering from lower profitability and rising asset quality issues, and digital service provider Tanla Platforms are among 20 stocks where retail investors are increasing their stake while institutional investors are reducing. In January 2022, shares of Tanla Platforms touched a high of ₹2,061 per share. By September 2024, they had fallen to ₹900. medium118753798From October to December, retail shareholding in the company had risen by 2% to 43%, while mutual fund holding had fallen to just 0.44%. From October till today, shares of the company have corrected by more than 50%.Investors are buying stocks that are falling. This is a good thing if these stocks have an intrinsic value and enough future growth to deliver returns. But data shows that retail investors normally flock to stocks that are falling or have fallen big time but have no value or growth to offer. Institutional investors are big sellers in these stocks. These are what you call lottery stocks. Not every stock is a loser, but in most cases, finding a winner is very difficult.Investors had purchased Vodafone and YES Bank when they were in a freefall but never got returns. They also bought Suzlon but in the case of this particular company, retail investors made money — at least those who waited for the long term.Decoding the lottery effectThe “lottery effect” describes how people overvalue small chances of large gains, acting as if they have a real shot at winning despite extremely low odds. This often leads to irrational decisions where they ignore the much higher probability of losing while focusing on the unlikely but potential reward.ET Prime formulated three indices — mutual funds, FPIs and retail — based on the top 20 stocks with the highest shareholders and whose percentage of shareholding in the company had increased in the past year. We compared their performances with the Nifty 50.We observed that the retail index was underperforming the FPI index. While the retail index gave negative returns in the past year, the FPI index was in green. The Nifty went down by 3% during the same period. medium118753818What is noteworthy here is that while the FPI portfolio mainly consisted of growth stocks such as Trent, Bharti Airtel and InterGlobe Aviation, the retail basket predominantly consisted of penny stocks such as Vodafone Idea and YES Bank.In the bull run after the pandemic, retail investors were doing well in the markets — even outperforming institutional investors. Even then, they had high shareholding in stocks like YES Bank, Indiabulls and BSE. But that was the time when small-cap stocks were outperforming mid- and large-cap stocks. With small-cap stocks bleeding in the current market, retail investors are feeling the heat too.Institutional investors sold extensively in October last year at ₹4.13 lakh crore and ₹3.18 lakh crore in February. Coupled with FII selling heavily in the cash market, the overall markets are also down. The Nifty 50 is down by almost 12% in the past six months.Besides Zomato and Bharat Electronics, all other stocks in the retail portfolio have given negative returns, whereas 12 out of the 20 stocks in the FPI portfolio have given positive returns, and nine have given more than 10% returns in the past year. Bharti Airtel and InterGlobe Aviation have given more than 40% returns each in the past year.In shares like IDFC First Bank, NHPC, Indian Renewables Energy and Jio Financial, the percentage of retail shareholding has increased drastically. For instance, retail held a 14% stake in IDFC First Bank, which now stands at 22%. But the bank’s net profit margin dropped from 9% to 3.6% in the past year. The net profit margin for NHPC has also dropped from 26% in December 2023 to 13% in December 2024.That is not the case with the FPI portfolio. The top performers in the past year — InterGlobe Aviation, Bharti Airtel and Info Edge — have also reported an increase in their net profit margins during the same period.The last wordIn 2023, 11 female sanitation workers from Kerala pooled in ₹250 to buy a lottery ticket and were overjoyed to find that they had hit a jackpot of ₹10 crore. Many retail investors too are investing in falling stocks, hoping to hit a jackpot.It is not that retail investors lose in each and every stock where they are punting big. In fact, this might work out well in large-cap stocks. Again, we have also seen that retail investors have been very smart throughout the pandemic — either through direct buying or even through SIPs (systematic investment plans). But then that was the bull market. We need to see how they perform in a bear phase.While buying falling stocks is a good thing, buying stocks with a low probability of high gains is like buying low-cost out-of-the-money put options. You can win big here, but the probability is very low. This happens in small companies.Now there is another way of looking at this. Retail investors are taking big positions in large companies. Will the lottery effect spill over to these stocks or will these stocks become genuine value buys? Only time will tell. As of now, data shows that institutions are winning, and retail investors are losing.