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Friedman-Savage and Retail Equity Investment in India

 5 min read / 

Traditional finance has ingrained in every economist the notion of diminishing marginal utility – implying that when one has more of a resource, one’s 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 futures and options trading 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, given that equity investing is a “risky” activity?

The “Normal” Utility Function

Apply deductive reasoning to the standard concave utility curve and what one infers is the decline in the desire to take a risk as your wealth increases.


Figure 1 – Diminishing Marginal Utility Function

If the incremental utility of additional wealth is lower, one’s risk appetite for generating that greater wealth should, theoretically, decline. With greater wealth, therefore, one is expected to be more risk-averse.

Friedman-Savage Utility Function

A simple scan of the equity market participants, however, reveals that reality differs from the above hypothesis. The theory of risk aversion posited by ‘diminishing marginal utility’ vexed Milton Friedman and Leonard Savage when they saw people buying lottery tickets as well as insurance policies to protect them against losses in their businesses. This contrasting display of risk-taking and risk-averse behaviour by homo sapiens prompted them to come up with their own edition of the utility function.


Figure 2: The Friedman-Savage Utility Function

The above utility function essentially exemplifies that one individual can have varying risk-appetites at different levels of wealth.

In region A, the lower levels of wealth, the individual is risk-averse. They want to make ends meet and fulfil basic needs. In this part of the curve, individuals do not want to lose their wealth. Therefore, individuals here buy insurance policies, thereby demonstrating a risk-averse nature commensurate with the diminishing marginal utility they see as the majority of their consumption is focused on necessities.

As income levels rise in region B of the above graph, necessities cease being a worry. The desire for luxuries increase and there is a rising marginal utility of wealth as discretionary spend becomes coveted. However, by region C, when wealth has further increased, 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, it seems that direct equity investment by Indian households is set to explode. As of 31st December 2015, there were just 480,000 accounts with broker NSDL. In a country with a population of over 1.2bn, it is safe to say that there is ample scope for growth.

Taking cue from the Friedman-Savage model, as India sees higher levels of per capita income, the nation will shift from region A of the curve to region B.  Average per capita income will enable Indians to comfortably service their basic needs and the aspiration for luxuries kicks in.

This corroborates well with the J-curve in consumption expected from the Indian population that was 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 the 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 India shifts from region B to region C.

Equity Investment in Developed Countries

Once India reaches region C, it will enter the early phase of being a developed country. 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 countries typically see a stagnation in retail equity participation around this level as well.

The USA is a classic example of this phenomenon.


Figure 3: Retail Participation in US Equity Markets

In the early 90’s, as the GDP per capita for the USA crossed the $20,000 mark, there was 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 and have been present since time immemorial. The Friedman-Savage double inflection utility curve gives a rational framework for think about retail participation in the equity markets (a so-called “risky” activity) even though Friedman and Savage may not have intended it to do so.

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