The 'fallacy of composition' has left equity fund investors reeling

An investment path that's good for individuals had the collectively bad effect of inflating stock prices

- VIVEK KAUL

Economist John Maynard Keynes came up with the concept of 'the paradox of thrift.' It's an excellent example of the fallacy of composition, where the whole differs from the sum of its parts—a situation where what's good at an individual level may not be so at a systemic macro level.

As Justyn Walsh writes in Investing with Keynes: "Keynes' most famous example of the 'fallacy of composition' was the so-called Paradox of Thrift—which notes that saving is good for the individual, but if all individuals increase their savings then aggregate demand will fall, eventually leading to lower savings for the population as a whole."

How the stock market behaves at different points is another example of the fallacy. As Walsh writes: "The stock market... can, on occasions, display emergent properties, where individual behaviour mutates into mob irrationality." So, it might make sense for an investor to buy stocks at a given point of time, but if too many investors start doing so, then prices go up too soon too fast, weakening their correlation with company earnings.

In India's case, much of the stock market rally between April 2021 and September 2024, when prices peaked, was driven by retail investors, particularly those investing in equity mutual funds (MFs) through the systematic investment plan (SIP) route.