Retail Participation, Easy Money and Surging Prices of Fundamentally Weak Stocks

In recent years, our share market has witnessed a surge in the influence of retail investors, a phenomenon exacerbated by increased access to market information. While this democratization of investing has empowered individual traders, it has also given rise to a unique set of challenges. One such challenge is the susceptibility of retail investors to the Fear of Missing Out (FOMO), a psychological phenomenon that often leads to participation in speculative acts and, subsequently, the inflation of stock prices for fundamentally weak companies. We can recently see this phenomenon in low-market-priced hydropower stocks where retail investors are participating in huge numbers. These investors are mostly inexperienced and often lack simple concepts of share market investment such as EPS (Earning Per Share), the company’s net worth, and Market Capitalization of the company among other concepts. This is well understood by experienced HNIs (High Networth Individuals) and institutions who for their own benefit help to trigger the FOMO trend.

Understanding FOMO in Retail Investing

FOMO is a powerful force that compels individuals to act based on the fear that they will miss out on a potentially lucrative opportunity. In the context of the stock market, this translates to retail investors rushing to buy into a particular stock when prices are rapidly rising, driven more by the fear of being left out than a careful consideration of the investment's underlying fundamentals.

The Role of Social Media and Online Communities

The advent of social media and online investing communities has played a pivotal role in amplifying the FOMO effect among retail investors. Platforms like Telegram, Whatsapp, Facebook, Twitter, and various online forums have become hubs where market sentiment is discussed, investment strategies are shared, and stock tips are exchanged. When retail investors witness others profiting from a particular stock, the fear of missing out can become overwhelming, prompting them to hastily join the euphoria.

Speculative Trading and Momentum Investing

FOMO tends to manifest in speculative trading behaviors and momentum investing, where retail investors are more inclined to chase after stocks that are already experiencing significant price increases. This herd mentality can lead to a surge in demand for shares of companies, even if their fundamentals do not support the heightened valuation. 

Easy Money and Stock Prices

The baking system implements easy money policies to encourage borrowing, spending, and investment. By lowering interest rates and injecting liquidity into the financial system, they aim to make it cheaper for businesses and individuals to access capital. In theory, this should stimulate economic activity, promote job creation, and lead to overall economic expansion. The recent decline in demand in our economy has forced our banking system to generate easy money by reducing interest rates. 

As Haward Marks of Oaktree Capital often says, history doesn’t repeat itself, but it does rhyme. The influx of easy money often finds its way into the stock market. Investors, seeking higher returns in a low- interest-rate environment, are drawn to equities. As demand for stocks increases, so do their prices. This surge in stock prices will also extend to fundamentally weak companies having less share float in the market, creating a disconnection between a company's valuation and its underlying financial health. The sector may or may not be different this time, but it would definitely increase the share price of an industry with increased liquidity and decreased interest rates.

Fundamentally Weak Companies and FOMO

Retail investors, lured by the prospect of quick gains, may overlook or underestimate the importance of a company's fundamentals in their pursuit of short-term profits. This can result in an influx of capital into fundamentally weak companies, artificially inflating their stock prices. This is usually observed in fundamentally weak companies with less market float. As retail investors pile into these stocks, the FOMO-driven surge can create a bubble that is unsuitable in the long run. 

Risks and Consequences

Participation in FOMO-driven stock surges poses significant risks for retail and inexperienced investors. When the hype subsides and the market corrects, those who buy into fundamentally weak companies at inflated prices may incur substantial losses. The lack of a solid foundation in terms of a company's financial health can lead to a sharp and abrupt decline in stock prices, leaving investors on the wrong side of the trade.

Furthermore, the collective actions of retail investors driven by FOMO can contribute to increased market volatility, impacting the broader stability of the financial system. We have experienced it via changes in regulatory guidelines from SEBON (Securities Board of Nepal) and NRB (Nepal Rastra Bank) in recent years. Naming risky companies by SEBON, assigning investment limits via various tools by NRB, and so on are a few of its examples. These volatilities in the long run impact the overall stability of the financial system.

Conclusion

As retail investors continue to play a more prominent role in the financial markets, it becomes crucial for them to exercise caution and conduct thorough research before getting captivated by FOMO. While the accessibility of information and trading platforms empowers individual investors, it also requires a heightened awareness of the risks associated with participating in surges of prices in fundamentally weak companies. A balanced and informed approach to investing is essential to navigate the markets and avoid the potential pitfalls of FOMO-driven decision-making. Finally, retail investors should also realize that investment and trading in the stock market are also businesses where only a few succeed and the rest learn.  

Article By -Astitwa Sharma