Why retail investors should diversify their portfolio and limit risky bets

The Securities and Exchange Board of India (Sebi) may soon impose limits on the trading positions that retail investors can take, based on their net worth. Retail investors will have to obtain a net worth certificate from a chartered accountant and submit it to their broker, and their trading limits will be decided accordingly.

Net worth is the sum total of all the financial and non-financial assets of an individual, minus his liabilities. Retail investors often do margin trading in the equity market, which means that they borrow money from their broker to trade in stocks. They also take leveraged positions in the derivatives markets, which means that they are able to take positions that are several times bigger than the amount of capital they have in mind.

The restrictions that Sebi plans to bring in are meant to curb such leveraged trading. "Once such restrictions come in, retail investors will not be able to take very large and risky positions that have the potential to harm them if the bets go wrong," says Ramabhadran Thirumalai, assistant professor of Finance at the Indian School of Business (ISB).

Many retail investors may not want to undergo the hassle of obtaining a net worth certificate. Many may also be reluctant to reveal their net worth to Sebi. Hence, the imposition of restrictions may propel more retail investors to invest through mutual funds.

This measure, however, also has a number of potential downsides. "Such micromanagement at the retail level is unwarranted. Sebi will only end up increasing compliance costs for retail investors without improving anything," says R Balakrishnan, an industry veteran who is now an independent analyst.  

Thirumalai fears that many retail investors may shift to dabba (off-exchange) trading, which is plagued by issues such as non-transparent pricing. He also fears that the move may result in prices going down and liquidity within the market declining as trading  volumes fall. "Instead of imposing such restrictions, Sebi should focus on enhancing financial literacy so that retail investors understand the risks in margin and leveraged trading, and the potential losses they can sustain by taking such leveraged bets," he says. Balakrishnan too is of the view that Sebi should just focus on enforcement of regulations and keeping the capital market clean for participants.

It remains to be seen whether these proposals will be implemented. However, the underlying point about retail investors managing their risks properly is valid.

Mutual funds should be the preferred vehicles for achieving most long-term goals. One way to manage risk is by being diversified. The basic rule of thumb is that your equity exposure must equal 100 less your age. This may be slightly increased or decreased on either side depending on the individual's own risk appetite. The rest of the portfolio should be put in debt which can provide stability and steady returns. A small portion may also be put in gold as a kind of hedge against equity market risk. An evolved investor may also take limited exposure in international funds, once he has taken adequate exposure in the Indian market, to reduce country-specific risk.    

A small portion of the equity portfolio may be dedicated to direct trading based on fundamental analysis, provided the investor has the time and ability to do the required research. Most retail investors should avoid margin trading or taking leveraged positions in derivatives. Only those having a very high net worth and the necessary risk appetite should engage in such bets, and that too in a limited manner. Derivatives should be used only by investors who understand these complex tools, and then too primarily as risk-hedging tools. If at all leveraged bets are taken, investors should fully understand the losses they can sustain if these bets go wrong and be prepared for them.