CIRCUIT BREAKER. Why the less affluent need equities

Should the poor be allowed to dabble in equities? An animated social media debate has been stirred up on this question after recent news reports suggesting that the Securities Exchange Board of India (SEBI) is looking to use net worth criteria to cap the domestic retail investor’s equity exposure. It isn’t clear yet if this cap is intended to protect retail investors from speculative stock market positions or targets even their long-term equity holdings.

But if SEBI is considering such a cap, it must think again. In the Indian context, low net worth investors have a far greater need of equities in their portfolio than rich folk.

Everest-like goals

India is an island of high inflation in the global context. This makes it an uphill task for Indians to meet their Everest-like financial goals with their savings, be it their children’s education or their own retirement. It is an established fact that equities fare better than other assets in delivering inflation-beating returns in the long run. This makes it imperative for small retail savers to invest in equities.

Take the case of a 30-year old with an annual income of ₹7 lakh (post-tax). If he spends ₹40,000 a month today, he will need to build up an ₹8 crore retirement corpus by age 60 to meet the bare minimum of his living expenses, assuming an inflation rate of 7 per cent. If this middle-income earner were to rely only on debt instruments paying 8 per cent interest, he would need to save an impossible sum of over ₹53,000 a month to get to his goal. But with an all-equity portfolio that earns 12 per cent, his monthly investment target halves to about ₹23,000. Clearly, only an equity allocation can help this middle-income earner at least get within touching distance of his retirement goals.

How much this equity allocation should be, will depend on the individual’s life stage, income, savings ability, lifestyle aspirations and goals. Fixing an arbitrary cap on this allocation based on current net worth would be retrograde.

Ponzi risk

In the past decade, SEBI’s investigations have unearthed dozens of Ponzi schemes masquerading as deposits, chit funds, convertible bonds and plantation schemes, that managed to swindle savers in rural India. The unifying feature of these schemes was their promise of high ‘fixed’ returns.

The fact that savers at the lowest end of the income spectrum, have been willing to commit thousands of crore to these Ponzi schemes shows that they do have a desperate need of higher return avenues, but lack the access, awareness and opportunity to invest in market-linked products.

Sure, allocations to the stock markets or mutual funds will expose such investors to market risks. But then, SEBI-regulated equity products are still infinitely safer for them than the Ponzi schemes or the unregistered chits that today make up their default investment avenues.

Superior liquidity

Textbooks may tell us that equities are the riskiest asset class because equity investors can lose their capital to volatile markets, or ups and downs of business cycles.

But in the real world, investors often lose their shirt to so-called safer assets too. In India, retail NCDs and fixed deposits offered by companies have been known to default on maturity or skip interest payments. Investors who favour gold jewellery routinely suffer a 20-30 per cent loss on liquidation owing to poor caratage, making charges and price fluctuations.

The last few years have starkly brought home the risks of real estate investing with buyers losing their lifetime savings to inordinate delays, incomplete projects or siphoning of funds by developers. For all their flaws, stocks and mutual funds are assets with anytime liquidity, where exit is assured even if at a beaten-down price. Investors with low net worth are the ones who most need liquidity in emergencies.

Still under-owned

Despite all the pluses of equity investing, policy-makers would be right to fret about excessive risk-taking if Indian savers were going over-board with equities carried away by the bull market.

But official data show that despite the recent flood of money into mutual funds, equities remain an under-owned asset.

RBI data on household savings for FY17 found that domestic households parked less than 2 per cent of their disposable incomes in shares, debentures and mutual funds.

A seminal study on household finances by the Tarun Ramadorai committee last year found that

only 55 per cent of the poorest population owned financial assets, while 90 per cent of the richest did. Pointing to their high indebtedness and lack of social security, the committee in fact recommended that the poorest households be incentivised to shift into financial assets to bump up their returns.

Why not net worth?

While the above arguments make a case for less wealthy individuals to be allowed into equities, shouldn’t there be curbs on how they take their equity exposures? Why not allow them into mutual funds, but restrict them from buying stocks directly, trading intra-day or playing derivatives?

Well, the problem with this approach is that it assumes that wealth, and not knowledge, is the pre-requisite to successfully managing the risks and navigating the workings of the stock market.

The stock market is today home to scores of retail investors who weren’t very wealthy to start with, but have mastered the art of fundamental stock selection, technical analysis or derivatives trading, by sheer dint of study and experience. Such investors serve as role models to others seeking to create wealth through the equities route.

Why deny individuals the opportunity to create such wealth just because they aren’t rolling in money?

In fact, the many scams that high net worth investors have fallen victim to — art funds, commodities trading, time share rackets — show that net worth has little to do with financial literacy.

If at all SEBI is still keen to introduce qualifying criteria for retail investors to dabble in stock trading or derivatives, it can use knowledge of the markets (say, through a written test) or experience (say, age of the demat account) as the eligibility criteria.

This is not to say that all retail investors pouring money into equity MFs or punting in the derivatives market today, are doing so with encyclopaedic knowledge of the markets.

A good number could be misinformed or victims of mis-selling or even misuse of their accounts by market intermediaries.

But the best way for SEBI to tackle this would be invest even more in financial literacy campaigns and to take swift punitive action against intermediaries who mislead their clients.