Traditional finance has ingrained in every economist the notion of diminishing marginal utility- implying that as you have more of a resource, your incremental utility of that resource decreases with every additional unit. Why does someone living a modest life comfortably on a steady income then feel the need to indulge in F&O or buy into an unknown company? How can there be a case for rising retail participation in India’s equity markets when incomes are rising (assuming equity investing is a “risky” activity)?
The “Normal” Utility Function
Apply deductive reasoning to the standard concave utility curve (see Figure 1) and what one infers is the decline in the desire to take a risk as your wealth increases.
If the incremental utility of additional wealth is lower, my risk appetite for generating that greater wealth should decline. With greater wealth, therefore, one needs to be more risk averse.
Friedman-Savage Utility Function
A simple scan of the equity market participants, however can reveal that the truth differs from that. The theory of risk aversion posited by ‘diminishing marginal utility’ vexed Milton Friedman and Leonard Savage as well, when they saw people buy lottery tickets and people buy insurance policies to protect them against losses in their businesses. The contrasting display of risk-taking and risk-averse behavior by homo sapiens prompted them to come up with their own edition of the utility function (see Figure 2).
The above utility function essentially exemplifies that one individual can have varying risk-appetites at different levels of wealth.
- A: At lower levels of wealth, the individual is risk averse; wanting to make ends meet and fulfill basic needs. In this part of the curve, individuals do not want to lose their wealth. Therefore individuals here would buy insurance policies, thereby demonstrating a risk averse nature commensurate with the diminishing marginal utility they see, as majority of their consumption is focused on necessities.
- B: As income levels rise, necessities cease being a worry. The desire for luxuries increase and voila! we witness rising marginal utility of wealth as discretionary spend becomes coveted.
- C: After a certain point, with a consistent increase in wealth, the avenues for discretionary spend are exhausted and we once again see the concavity in the marginal utility function appear, exhibiting its diminishing nature.
Retail Participation in Indian Equity Markets
Extrapolating the Friedman Savage Utility Function to understand retail participation in Indian Equity Markets, I posit that the direct equity investment by Indian households is set to explode.
As of 31st December 2015, there were 48 lakh unique individual demat accounts with NSDL. Let us assume that by end of 2016, NSDL and CDSL have a total of 1 crore unique individual demat accounts. In a country with a population of over 120 crores, it is safe to say that there is ample scope of growth. The low penetration of direct equity investment is however not a novel factor. If anything it has been even lower in the past: so why the big clamor for increase in participation now apart from the fundamental reasons listed out in my earlier post: The Valuation Impediment Revisited?
Taking cue from the Friedman-Savage model; as India sees higher levels of per capita income, we are shifting from ‘Region A’ of the curve to ‘Region B’. Our average per capita income helps us comfortably service our basic needs and the aspiration for luxuries kicks in. This corroborates well with the J-Curve in consumption expected from the Indian population as seen in China in the past decade. The marginal utility of wealth in this country therefore is set to rise which consequently implies a greater risk appetite for creation of this wealth. It is this rising marginal utility and therefore a seeping in of a risk-taking attitude that will contribute greatly in people moving away from fixed income assets to equity investments within their financial savings allocation.
The J-Curve in consumption in other economies has been noted at around $2,000 per capita income level. This is where India currently is at. The journey of rapid increase in retail participation in equity markets should continue until we shift from ‘Region B’ to ‘Region C’. In my opinion, ‘Region C’ would start only post the early phase of being a developed economy. Though a lot of qualitative factors go into determining whether an economy can be deemed as developed or not, evidence suggests that this title is conferred upon those who see per capita incomes north of $15,000-$20,000. What is interesting to note is that we see a stagnation in retail equity participation around this level as well. USA is a classic example of the same (see Figure 3).
In the early 90’s, as the GDP per capita for US crossed the $20,000 mark, we witnessed a stagnation of the retail participation in the equity markets. An incremental $35,000 GDP per capita and two bubbles later, we are now seeing a clear trend of decline in the percentage of US adults investing in the stock market.
Sentiment would have surely played a part in this decline but one must remember that bubbles are not unique to this time frame. They have been present since time immemorial.
The Friedman-Savage double inflection utility curve just posits a rational framework to think about retail participation in the equity markets (a “risky” activity) even though they may not have intended it to do so.
May 2, 2017 at 2:30 am
interesting application of the MU function principle. there are 2 facets that fascinate me in this space.
a) the increased interest in derivatives and its co-relation with risk taking (a point that you’ve observed as well) – for the fact that we are merely hovering around ‘region B’ as a country and that equity participation by retail investors is yet to reach its potential, the volume of trades in F&O as against cash settlements in the equity markets is mind boggling! almost every retail investor that i speak with is into F&O. I wonder if this is indeed calculated risk taking or greed raising its hood (in which case greed actually overpowers fear which is interesting!). and I thought derivatives were actually used for hedging and not speculation (insurance vs money making)….maybe a topic for another day.
b) the co-relation of our changing demographics to risk taking – with a good % of our population being under 35 years of age, i wonder if we are also seeing a difference in the risk taking abilities of the investing population compared to previous generations. for eg: I find the Gen Ys and millenials to be informed risk takers and I therefore wonder if they might give the theory of MU a run for its money. my logic is this: with a high risk taking ability at such a young age, the millenials could turn out to be smart investors/traders who make good money. with an almost insatiable risk taking attitude,I feel they might only want to experiment more with their money which might exploit their monetary utility even more. could well be a combination of smart risk taking and passion overpowering the marginal utility of their increasing money