How investors lose money to an addiction

Editor's Note Dhirendra Kumar’s insights and timeless advice for investors --------------------------------------------------------------- 03-August-2024 --------------------------------------------------------------- Dear {NAME}, Every Saturday, I share my perspectives on a topic investors will find useful. This time let’s look at how small investors are losing more than Rs 63,000 crore a year. Retail investors and the derivatives trap SEBI has come up with a consultation paper on “Measures to strengthen index derivatives framework for increased Investor protection and Market stability”. Translated into non-officialese language, it means measures to somehow slow down the rampant loss-making speculation by investors in index derivatives. A couple of years back, the regulator came out with that study that became famous (or infamous, depending on your point of view). We learned at that time that some 89 per cent of derivative traders lose money. We also learnt other damning things about F&O gambling, but that was the headline view. Now, we have this new paper which has a good amount of fresh data analysis as well as a slew of proposed reforms that aim to solve some of the problems that have been pointed out. While few readers will have the wherewithal to go into the nitty-gritty of the detailed analysis, I think the crux is this: For FY 2023-24, 92.50 lakhs unique individuals and proprietorship firms traded in the index derivatives segment of NSE and cumulatively incurred a trading loss of ₹51,689 cr. This figure doesn’t include transaction costs. Further, of these 92.50 lakh unique investors, 14.22 lakh investors made a net profit i.e. approximately 85 out of 100 made a net trading loss (source: NSE data). The SEBI study referred to above found that over and above the trading losses, the loss-makers expended an additional 23 per cent of trading losses as transaction costs, while profit-makers spent an additional 15 per cent of their trading profits as transaction costs during FY22. After considering the transaction costs, the outcome for FY24 will likely be very comparable to our FY 22 study, which found 9 out of 10 losing money. On the other side, it has been observed that larger non-individual players that are high-frequency algo-based proprietary traders and/ or Foreign Portfolio Investors (FPIs) are, in general, making offsetting profits. Please read this carefully once again. This is the heart of the matter. Almost all individual investors lose money, and that money goes straight to high-frequency algo traders, FPIs and other similar entities. Some readers may be puzzled by the phrase ‘offsetting profits’ because they may not know the zero-sum nature of derivatives trading. All profits come from someone else’s losses. In fact, this is the case if we ignore costs. Once you take costs into account, they are a negative-sum game. The huge impact of costs is also made clear in the above quote from SEBI’s paper. So that’s the bottom line. The sophisticated, large operators are just taking away money from retail investors who keep losing in the illusion that they could strike it rich at some point. With costs, the loss quoted above was Rs 63,600 crore in 2023-24. That’s the basic flow of money here. Small investors gifted away Rs 51,689 crore to large operators and paid an additional Rs 11,888 crore to the brokers and NSE for the facility of making these losses. Do you see where the economic interests lie? And do retail investors understand the unalloyed stupidity of just giving away their money? The question is, will SEBI’s proposed measures make any difference? Many people are sceptical. My view is that there is never 100 per cent success or 100 per cent failure in such issues. If implemented, these measures will definitely reduce the tendency to do disastrous trades. The increase in ticket size will also mean that – to put it bluntly – derivative trading will be limited to slightly richer people, so hopefully, they won’t feel the loss as much. It’s also possible that no significant change will take place, and both punters and the industry will find a way around the new rules. Most of the proposed changes are efforts to modify investor behaviour. This does remind me of Charlie Munger's quote on incentives from his famous Harvard speech: “Show me the incentives, and I'll show you the outcome.” Will this change the exchanges' and brokers' incentives? Will it change investors' incentives? Even so, I think there’s a very important process that has started, which is to give derivatives trading a bad name. I do mean that. When someone gets into derivatives trading, I’d like the trader’s family and friends to react in the same way as they would if that person were trying out drugs. This entire activity is gambling, which is an addiction. I hope that the narrative around derivatives trading changes to thinking of it as a dangerous and lethal addiction. --------------------------------------------------------------- Thank you for being a Value Research Insider. I hope you found this note useful and interesting. What did you think of today’s note? [Let me know](mailto:editor@valueresearch.in). If you know anyone who would enjoy it, please forward this email. They can sign up for free [here](. You can also subscribe to the Hindi version [here](. Was this email forwarded to you? [Sign up here]( [vro-logo]( Copyright © Value Research India Private Limited 2024. All rights reserved. C-103, Sector 65 Noida, 201301. 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