While a cooling economy and falling corporate profits are often cited as reasons for the poor performance of Chinese stocks, increasingly contributing to the downtrend is the disappearance of the retail investor.

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Stocks on the mainland staged one of their worst performances this year, with the Shanghai Composite Index tanking nearly 13% in the last six months, making the market the biggest laggard among its Asian peers.

"The stock market in China is manipulated too much, making it more like gambling rather than investing. The market always goes in an unreasonable way that contradicts our financial knowledge," 31-year-old Hong, who runs a medical equipment trading company in the coastal city of Wuxi, told CNBC.

Hong, who requested to be identified by only his last name, began investing in mainland stocks during the bull run of 2006, but earlier this year exited all his equity positions owing to the "volatility in the markets."

Retail investors account for around 80% of the turnover at China's two stock exchanges in Shanghai and Shenzhen. Combined turnover at these two bourses fell 32% year-on-year in the first six months of 2012, according Shanghai-based consulting firm Z-Ben Advisors.

Another indicator of falling interest is the decline in the number of retail broker accounts being opened. Approximately 360,000 such accounts were opened in July, less than half of the 790,000 opened in the same month last year, according to a Nomura report.

Individual investors in China's domestic stock markets are finding it increasingly difficult to make money in the current environment, forcing them to cash out of their investments and put their money in less volatile alternatives, including property and wealth management products, say experts.

"It takes strength to remain optimistic in this market, people are trading less because they are fed up with the ups and downs in the stock market," said Howhow Zhang, head of research at Z-Ben Advisors.

Even a slew of government stimulus measures over the past two weeks, including the USD 150 billion-plus in infrastructure spending and incentives for exporters, have failed to drive a sustainable turnaround in the market. While this did lead to a temporary rally in the first week of September, it soon fizzled out.

"The government has been sending positive policy signals ... but everyone's stopped paying attention," Zhang said.

As investors shift away from risky assets, like equities, Zhang says he has seen a significant rise in demand for fixed-income products this year.

Hong, for example, has since put his money in different investment products offered by his bank, which earn him an annual return of 5% to 9%.

"A lot of investment firms are launching short-term bond funds which give you returns of 4% to 5% a year," Zhang added.

Unlike the equity market, China's bond market has been thriving. Chinese bond funds enjoyed their largest-ever net inflows in the second quarter this year, according to Reuters, raising total bond fund assets to an all-time high.

Retail Interest Has Peaked

This loss of interest among retail investors is not a short-term phenomenon. According to Hong Kong-based Wendy Liu, head of China equity research at Nomura, retail interest in A-shares - those traded on local stock exchanges - has in fact peaked.

Based on a study, which looks at historical A-share fund flows, retail broker accounts and money raised by mutual funds, among other data points, Liu said retail investment into domestic shares reached its highest point in 2007.

"Household ownership of stocks, stock funds, and stock accounts saw their biggest increases in 2007. Subsequent net increases in 2008, 2009, 2010 have been modest (in comparison)," Liu said.

Chinese stocks entered a bull run between 2006 and 2007, when the Shanghai Composite hit a peak of 6,124.04 in October 2007. The market has not seen those levels since, trading in the range of 2,145 to 2,530 over the past year, and experts say there is no catalyst for it to return to those levels in the foreseeable future.

Role of Foreign Investors Limited

While China has stepped up efforts to expand foreign participation in the Chinese market, overseas investors continue to play a small role.

Foreign investors require a license under the qualified foreign institutional investor program, known as QFII, to access its financial markets.

In April, the government increased the investment quota under the QFII program to USD 80 billion from USD 30 billion previously. In total, China has granted QFII licenses to 181 foreign investors, 149 of whom have combined quotas of USD 28.53 billion, according to Reuters.

"That's a very small amount, less than a couple of days turnover in the market ... the average daily turnover is around 70 billion yuan (USD 11 billion)," Philip Chan, director at Shenyin Wanguo Securities, said.

Luring Investors Back

For retail investors to return to the market, there has to be a significant rebound in domestic stocks of around 15% to 20% over the course of one month, said Zhang, who has a "neutral" outlook on Chinese equities.

He added, however, that low valuations and the completion of the leadership transition later this year could provide some support to the market.

"When the new regime is elected, it will remove a lot of uncertainty in the system that will make investors more comfortable to assume a little bit more risk," Zhang said.

-By CNBC's Ansuya Harjani

Copyright 2011 cnbc.com

First Published:Sept 18, 2012 8:40 AM IST