Limiting risky, leveraged bets
Sebi’s proposal to link trading position with net worth will force investors to stop overleveraging
The Securities and Exchange Board of India (Sebi) might soon impose limits on trading positions that retail (individual) investors can take, based on their net worth. Retail investors will have to obtain a net worth certificate from a chartered accountant (CA) and give it to their broker; their trading limits will be decided accordingly.
Retail investors often do margin trading in equities and also take leveraged positions in derivatives. This essentially means they take positions several times bigger than the amount they have in hand.
Sebi’s proposed restrictions will aim at curbing 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 might not want to undergo the hassle of obtaining a net worth certificate. Many could also be reluctant to reveal their net worth. Hence, the restrictions might propel more of them to invest through mutual funds (MFs).
The measure could also have downsides. “Such micromanagement at the retail level is unwarranted. Sebi will only end up increasing the compliance costs for retail investors,” says R Balakrishnan, an independent analyst.
Thirumalai says he fears many retail investors might also shift to dabba (off-exchange) trading, which is plagued by non-transparent pricing. He also fears it could result in prices going down and liquidity declining on the exchanges.
“Instead of imposing such restrictions, Sebi should focus on enhancing of financial literacy so that retail investors understand the potential losses by taking leveraged bets,” he says.
It remains to be seen if these proposals are implemented. However, the underlying point about retail investors properly managing their risks is valid. Most of them should rely on MFs to achieve their long-term goals.
One way to manage risk is by being diversified. The basic rule is that your equity exposure be equal to 100 less your age in years. You could then slightly increase or decrease your exposure based on risk appetite. The rest of the portfolio should be put in debt for steady returns. A small portion could also be put in gold as a hedge against equity market volatility. An evolved investor may also take limited exposure to international funds, to reduce country-specific risk. Having an investment horizon of more than five years in equity funds will also enable one to deal with volatility.
Investors who have the time and ability to do the required research may invest a small portion of their portfolio in direct equities for the long term. Most retail investors should avoid taking leveraged positions in equities or in derivatives. Only those with a high net worth and the necessary risk appetite should engage in such bets, and in a limited manner. Derivatives should be used only by investors who understand these complex tools. “If trading in derivatives, only use money that you can afford to lose. Do not take money out of your core portfolios because a huge loss will set you behind visa-vis your major financial goals,” says Mumbai-based financial planner Arnav Pandya. Second, be strict about using stop-losses when doing derivative trading. Finally, if you have had a few good trades, do not get overconfident; one bad trade can wipe out the gains from several good ones.