The article has been authored by Dr. Sayantan Kundu, Assistant Professor (Finance), IMI Kolkata.
Over the last decade, a significant shift in the investment behaviour of Indian investors has occurred. More investors, particularly the younger, digitally savvy generation, are opting for equities (equity stocks and equity-based mutual funds) instead of traditional bank deposits.
The share of equities in household savings doubled from 2.5% in FY20 to 5.1% in FY24, according to SBI Research. Viewing this trend through the lens of game theory allows us to better understand how strategic decision-making, coordination issues, and perceptions of risk and reward influence collective behaviour in the financial markets.
The Investment Game: A Strategic Dilemma
At its core, the decision between investing in bank deposits or equities can be seen as a game involving multiple players (i.e., individual investors) choosing between safer, lower-yield options (bank deposits) and riskier, potentially higher-yield investments (equities). The payoff for each investor depends not only on their own choice but also on the collective behaviour of other investors.
Nash Equilibrium and the Coordination Game
In game theory, a Nash equilibrium occurs when no player can improve their payoff by unilaterally changing their strategy. In the context of investment choices, let us consider two simplified scenarios:
Scenario One – Coordinated Choice for Safety: Deposits offer a certain return protected by deposit insurance (up to 5 lakhs per user), making them a safe haven in uncertain times. Imagine a situation where most investors opt for bank deposits. In this equilibrium, every investor gets a modest but certain return. Although the outcome is predictable, particularly during volatile market conditions, the payoff is limited by the prevailing low-interest rates, a reality in India’s current banking landscape.
Scenario Two – Coordinated market optimism and liquidity flood: Alternatively, if a critical mass of investors decides to favour equity market investments, a new equilibrium begins to emerge. With more capital flowing into equities, the market benefits from increased liquidity and higher valuations. In this coordinated scenario, even if there is an inherent risk in equity market volatility, the collective expectation of higher returns, fuelled by improved corporate performance and economic optimism borne out of India’s growth story, can dominate individual risk concerns and deliver better returns like a self-fulfilling prophecy.
This interdependence exemplifies a coordination game. Every investor’s choice not only impacts their own returns but also signals confidence in the market, a cue that might encourage others to follow. A core idea in game theory is the information cascade. When influential investors make bold moves into the stock market, their actions communicate private confidence in the economy.
This influences the behaviour of less-informed investors and can create a self-fulfilling prophecy, as many followers jump into the market based on these signals, causing stock prices to rise and reinforcing the decision to prefer equities over bank deposits. The outcome often results in an equilibrium where equity investments dominate, even if they are typically riskier than bank deposits.
A Simple Payoff Matrix Illustration
Consider a simplified two-player model where each investor chooses between Deposit (a safe, low-yield option) and Equities (a risky, potentially high-yield alternative). The payoff matrix below outlines hypothetical returns with higher numbers representing better outcomes. The first number within parentheses indicates the payoff for the first investor, and the second number indicates the same for the second investor.
| Investor 2: Deposit | Investor 2: Equities | ||
| Investor 1: Deposit | (3, 3) | (2, 4) | |
| Investor 1: Equities | (4, 2) | (5, 5) | |
When both investors choose Deposit, they secure moderate and certain expected returns (3, 3). However, if one invests in equities while the other remains cautious with a deposit, the equity investor might receive a relatively higher payoff (4) if market support and information advantages are present, while the other might earn less (2) due to opportunity costs or regrets. Conversely, if both opt for equities, the scenario described above – coordinated market optimism and liquidity flood – can push the expected returns higher (5, 5) for both.
Although a simplified model, this matrix demonstrates that the “best” outcome (the Nash equilibrium) occurs when both investors choose equities. For individual investors, the decision to opt for equities is predicated on their belief that enough others will do the same to validate and sustain the higher payoffs.
Why this shift in India?
Several factors are at play in contemporary India to make equities more appealing.
First, with bank deposit rates historically offering minimal returns in the current low-interest regime, the deposit returns have gone below the certainty equivalent rate of equity investments.
Second, Structural reforms and improved corporate governance have bolstered investor confidence, encouraging a preference for equity investments.
Third, the advent of digital trading platforms and ensuing competition among brokers has reduced transaction costs and democratized market access, making equity investments more attractive to a younger, tech-savvy demographic. The advent of mobile-based trading apps has allowed them to access the market for data and trade 24×7.
Fourth, the access to transparent, cheap and reliable market data that was unthinkable even a decade ago in this country, today allows investors to continuously update their beliefs based on the observed actions of peers, a dynamic that sets the stage for rapid shifts in collective behaviour.
Lastly, peer influence and social media also play an important role. Information cascades are further amplified by online forums and social media, where investment decisions are shared widely, pushing the collective move toward equities, leveraging greed and fear of missing out (FOMO).
Conclusion
As more investors speculate on the equity market, the interaction of individual risk-reward preferences, coordination games, and information cascades not only shifts the equilibrium towards higher risk-high reward dynamics but also amplifies the signals that promote further participation, creating a virtuous cycle.
However, when negative information appears and greed turns to fear, the same mechanisms can turn the system into a vicious cycle, significantly increasing volatility. Therefore, understanding these strategic interactions provides valuable insights into market behaviour that can assist investors and policymakers in navigating the evolving financial landscape more effectively.
