IPOs and the Farce of Regulation Based on the ‘Rational Man’
In mid-July last year, CarTrade, a website to buy and sell used cars and car financing, got listed. The initial public offering (IPO) was priced at Rs1585.
 
Last week, its stock price closed the week at Rs640, a loss of 60% in seven months. A couple of months later came Policybazaar, with its IPO priced at Rs980. Last week, the stock closed at Rs524, a fall of 47%. A week after Policybazaar came Paytm, the ubiquitous payment platform, which made an issue at Rs2,150. It was the biggest-ever IPO. Last week, Paytm’s price was Rs709, a fall of 68%. Most other IPOs of the past year have met with a similar fate, including the big daddy of them all—Life Insurance Corporation of India. Many people took to social media to complain bitterly about the rapacious pricing of IPOs and blame the market regulator for allowing greedy issuers and investment bankers to gyp the innocent public. 
 
This phenomenon—IPOs quoting well below the issue price—is not new. IPOs are usually a bad deal for retail investors. This is because investors have no control over when to buy and at what price to buy—two crucial factors that determine returns. In an IPO, these two factors are dictated by the promoters and investment bankers. They fix the time and price to benefit themselves. But then investors ought to have done their homework before making a decision to buy. They didn’t. They allowed themselves to be influenced by intermediaries, brand, hype, greed, etc. That is also not new. It is the same story every time and at every place. This is what John Rothchild, a financial writer, famously said about investors in his book, A Fool and His Money: The Odyssey of an Average Investor. “People who spend a week choosing a furniture refinisher will sign up with the first [financial planner] who calls. People who circle junkyards for matching hubcaps will buy mutual funds without reading the prospectus. People who check the expiration date on cottage cheese would not think of investigating the background of their broker…” 
 
Here is what is interesting. If most investors invariably act like this, at every time and place, it means that we are all fundamentally flawed as humans, when it comes to making financial decisions. We just cannot help it. We seem to be hardwired in a way that forces us to make such mistakes. Indeed, behavioural finance does establish this to be true with umpteen experiments that have been conducted over the past four decades. Faced with multiple choices, when we are supposed to be think carefully, we act impulsively. The antidote to such mistakes is to train our minds to deal with biases and also historical knowledge. But financial literacy is not a part of the academic curriculum in India, nor are we made aware of our inherent behavioural biases. Indeed, no one even tells investors the most important truth about investing—that it is a battlefield out there and they are on their own; no one is their friend. Hence, it is obvious that making financial mistakes would be the norm, and a diligent, well-read and thoughtful investor would be the very rare exception. 
 
That most people behave irrationally is not new, you would say glibly. Yet, all regulations are framed with the ‘rational man’ in mind, just as economists adopted the concept of ‘the economic man’ to explain that, faced with economic choices, we would seemingly maximise our gains at any cost, which is often untrue. The concept of rational man has yielded the concept of disclosure-based regulations. The practical implication of this ridiculous regulatory assumption is that investors (rational people) are supposed to read 500 pages of legalese in an IPO prospectus, think hard, do a lot of research, probably create financial models and then decide whether or not to invest. If they have not done all of that, well they cannot complain. Disclosure-based regulations for the rational man are a charade but it would be hard to dislodge this since it is now a regulatory orthodoxy and serves the interests of investment bankers and issuers. 
 
In fact, not only are we likely to continue with the nonsense of disclosure-based regulations, we are likely to get a lot more of it. Last week, the news agency PTI quoted an anonymous senior official of the Securities & Exchange Board of India (SEBI) saying that the regulator will harness the ‘huge capabilities’ it has created over the decades, including cutting-edge technology and data to 'analyse things that have gone good or bad for the investors' and pass it on in the form of 'risk-factor disclosures'. It aims to help investors 'avoid the herd mentality that has been particularly visible in recent years' beginning with the pandemic and also the ‘recent losses sustained by investors’ in IPOs and derivatives transactions. In a global first, it would assist investors through monthly 'risk factor disclosures' on market trends, including surges and crashes. Well, I can guarantee nobody would read such disclosures, or make decisions based on them, just as they don’t read IPO prospectuses. It is quite amazing that, decades after behavioural finance has shown us the truth about real-life human behaviour, regulators cannot stir themselves to drop the rational man assumption and incorporate even a smidgeon of that learning. The current disclosure-based system created by regulators does nothing to actually help the investors. But it is investors alone who pay the price, not the regulators.
 
After this article was published in Business Standard, financial expert Saurabh Sonthalia came up with some excellent suggestions on how to make the IPO pricing more just and fair. You can read it here:  https://saurabhsonthalia.wixsite.com/ nomadicmusings/post/reforming-the-indian-ipo-market
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