A strategy to beat that ‘missed out’ feeling

A sudden gush of FII money has propelled the Nifty to a 1000 points gain from its Dec ‘11 low, and caught experts and small investors unawares. What had looked like a typical bear market rally is beginning to look more like the first stage of the next bull market.

Many who failed to buy at the low prices of 2011, and those who booked profits and moved to cash in the hope of buying at much lower prices, are feeling that they ‘missed out’ on the rally. How do investors ensure that they don’t miss out on opportunities to buy (or sell)?

In this month’s guest post, Nishit discusses the FoC (Free of Cost) strategy to beat that ‘missed out’ feeling.

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The stock market has rallied more than 20% from the Dec ’11 bottom. Many of us are feeling left out from this rally. What must one do to avoid such a situation? The stock market is one place where one can create a lot of wealth over the long-term. So, how does one go about doing this?

Step 1: Identify about 10 businesses which you feel will do well over the long term (as in next 5-10 years). Remember you are investing in businesses - not only stock prices.

Step 2: Once these businesses are identified, keep a watch on their stock prices. The strategy one will adopt is to keep investing into these stocks at regular intervals.

Step 3: With knowledge about the stock market and Nifty, buy these stocks at attractive valuations. There are 3 things which can happen to the stock prices. They can go up, go down or remain flat.

1. If the prices go down, be ready to average the stocks and buy them at a cheaper rate. For doing this, awareness of the broader trend of the market helps a lot.
2. If prices go up, be ready to book profits. One very effective way of doing this is by making the shares ‘Free of Cost’. Let me give you the example of SAIL. Say 100 shares were bought at Rs 90. Now the price has rallied to Rs 110. I feel I had enough of the ride and expect a correction in the markets. I book out 84 shares and remove my cost price. Now, the remaining 16 shares are free for me (i.e. my holding cost becomes zero). I know that SAIL will continue making steel for the next 10 years (and may be much longer than that). These 16 shares I will not touch unless there is a blow out rally where the Nifty trades in 22 + P/E which would be around 6300+.
3. If prices remain flat, I just wait and watch.

With this strategy, I will not be sad if prices go up and I have not bought anything fresh. If prices go down, I will be having cash to add to my holdings.

The risks to this strategy are the identification of the companies. If one goes for fly-by-night operators and the company goes bust, then one is in trouble. The ‘Free of Cost’ shares become worthless. Hence one has to keep a watch on the fundamentals of the companies and take a call to move on to other stocks.

This approach combines both fundamental and technical aspects. In the last year itself there were 4 bear market rallies. Even if one had booked with about 15-20 % profits one would have had a sizeable quantity of ‘Free of Cost’ shares right now.

This is one way to create long term wealth in the stock market.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

10 Reasons why small investors should love a bear market

Most small investors detest a bear market. The helpless feeling of watching stocks bought with hard-earned money falling into oblivion can be quite traumatic, and cause sleepless nights.

In a desperate and misguided effort to salvage a losing position, investors start ‘averaging’ – buying more shares at progressively lower prices. The stock doesn’t know that some one is ‘averaging’ it – and keeps going down further! The ‘average’ price of the stock decreases, but the losses increase.

Is there any remedy for this fairly common ailment? Turn a disastrous situation into a learning experience. Find out the reasons why small investors should love a bear market. Here are 10 of them.

1. Every one loves bargains. The best bargains in stocks are found during a bear market. Good stocks are available at 40%-50%-60% discounts to their recent peak values.

2. Experts and analysts appearing on TV or writing in business papers stop recommending third rate stocks. They may actually discuss about some decent companies. No longer will you hear that Suzlon is a great buy or Bartronics is the next Infosys.

3. Email or cell phone inboxes will not get overloaded with SMS stock tips about unknown companies from unknown brokerage houses. Most of those brokerages go belly-up during a bear market.

4. No one wants to discuss about stocks at weddings or college reunions. One can actually have intellectually stimulating conversations with relatives and friends – instead of saying “I’ve bought this” or asking “Why did you sell that?”

5. Working hours will not be wasted by staring at stock tickers scrolling on computer terminals. Up to the minute stock updates on cell phones will get disabled. Productivity at work places will improve.

6. One can get a haircut or a shoeshine in peace without getting stock tips from the barber or the shoeshine boy.

7. A bear market separates the short-term, one-hit rock-star companies from the true long-term wealth creating companies. The stocks that don’t fall much in a bear market are the ones that provide dividend income and stability to your portfolio.

8. If one is unfortunate enough to come face to face with a bear in a forest, the best thing to do is not to run or try to fight but to play dead. In the stock market, one can play dead by investing in fixed income avenues. Interest rates are usually higher at such times.

9. The importance of proper asset allocation becomes clear. Spreading investments among equity, fixed income, gold and cash not only saves a portfolio from annihilation but the asset allocation gives clear signals about when to buy and when to sell.

10. A bear market tests an investor’s mettle. Those who turn tail and run are just not meant to be successful investors. Those who can stick it out and learn from their mistakes are the ones who may be able to build wealth over the long term. 

Are you ready to splurge at the discount sale in the stock market?

Discount sales in retail stores happen several times during the year. They advertise ‘buy-one-get-one–free’ sales and ‘upto 50% discount sales’ that bring in buyers by the hordes. If you have ever visited a retail store on the last day of such a sale, you will find a scene of utter devastation – stuff strewn all over the place and buyers practically yanking things off other buyers in a last desperate bid to find a bargain buy.

What is interesting is that the same buyers (or their friends or cousins) become completely reticent when a discount sale is going on in the stock market – keeping their wallets glued to their pockets. No one rings a bell or takes out full-page advertisements in newspapers to announce a sale in the stock market. One fine day, when everything seemed to be full of sunshine and happiness, people realise their stock or mutual fund portfolio is decreasing in value. Stocks and funds that were flying into orbit suddenly start to nose-dive.

The initial reaction is usually denial. This must be a temporary phase. The correction will soon be over. Experts suggest: “Buy the dip”. Those who entered a bull market late (they are mostly new investors attracted like flies to a pot of honey) start ‘averaging’. When the stock market continues to fall, denial is replaced by shock. All the ‘averaging’ does not prevent a stock’s price from crashing. In sheer panic, investors sell off their holdings to recover whatever little they can.

That is when the real sale starts in the stock market. Experts opine that the index can’t fall any more; 4700 or 15700 or some such number should be the bottom; this is a good time to buy into blue chips. And then the stock market decides to offer even better discounts! But where are the buyers? Why aren’t they falling over each other in trying to lock-in the best bargains?

Many years ago, in a training class on the art of selling, I learned two important lessons. The first lesson: When some one leaves you a message stating that the ‘matter is very urgent’, the urgency is the person’s who left the message. He has probably not yet met his quarterly or yearly sales target – which means no bonus payment and may be even a ‘pink slip’. Don’t call the person back. Let him call again.

The second lesson: When some one offers you a very good deal – so good that you are tempted to whip out your cheque book – smile politely and refuse. The deal will usually get even better! Those who have negotiated a car purchase – particularly a second hand one – will know what is being discussed.

The same goes for Mr Market. He announces discount sales only once in two or three years – not several times a year like retail stores. But if you have the patience and skill to ‘negotiate’, keep smiling and refusing to accept his offers. Even if strong performers are trading at 52 week lows. You will find that his offers get even more mouth watering.

At some stage, Mr Market will get fed up with you (and others like you) and start increasing prices – not in one shot, but gradually. Much like the way he kept offering better discounts with each passing week. That is the best time to start buying. You may not get the absolute lowest bargain price. But you can sleep peacefully at night knowing that henceforth, prices will start rising. 

Do investors have the ‘if-its-free-I’ll-take-two’ syndrome?

Before I can answer the question, I need to tell the story about the syndrome.

A young boy was being taught by his father about prudence in handling money. Here are the three important guidelines provided by the father:

• Live within your means and try to save money from whatever little you may have
• Always ask the price of anything you wish to buy, and then decide if you can afford to buy it
• Don’t blindly accept a quoted price; try to bargain and buy at a lower price

Well-versed in the guidelines, the young boy went to the local ‘paanwala’ to buy some candy. On being told that the candy cost a Rupee, he promptly started to bargain. Despite repeated pleas by the ‘paanwala’ that there was no discount on a candy costing a Rupee, the boy would not relent. A small crowd had gathered on hearing the commotion, and potential customers were walking away. In desperation, the ‘paanwala’ handed over a candy to the boy, saying: “Take this. It’s free. Now please leave.” The boy was delighted, but refused to budge. “It’s free? Then I’ll take two!”

That boy must have grown up to be a stock investor. He also must have told all his friends – who also became stock investors. How do I know this? Because of the proliferation of web sites offering “sure-shot free stock tips” and “99.9% success guaranteed Nifty tips”.

There was a time when I used to go out of my way to provide free advice to young investors about what stocks to pick and how to build a portfolio. But I no longer give free advice – except in my blog posts. Why? Because I found out that most investors were not following my advice at all. In fact, they were doing just the opposite. They would not buy the stocks I’d recommend, and would go right ahead and buy the stocks I suggested that they avoid!

Then a wise reader related the story of a doctor in a small town who decided to treat patients for free after his retirement. Hardly any one showed up at his chamber. Then he decided to charge a reasonable fee. Soon, he had several patients visiting his chamber every day. The moral of the story is: No one respects free advice.

The other day, I received an email: “Can you please suggest one multibagger stock?” Usually, I ignore such emails, or answer back: “I don’t provide free stock advice.” But I was in a genial mood that day, and wrote back: “Buy Tata Steel.” The response floored me completely. Let alone thank me, this smart fellow came back with: “Any penny-stock multibagger?” This is what I meant by ‘if-it-is-free-I’ll-take-two’ syndrome!

A more dangerous affliction is the ‘if-it-is-free-I’ll-take-as many-as-possible’ syndrome. I got this email from such an investor: “I would like to buy some fundamentally strong stocks in this bear market. Please send me a list of such stocks.” I answered: “I don’t give individual stock advice for free. But you can take a look at some of the beaten down stocks in the Sensex and Nifty indices.”  Back came a response: “OK, I promise to send your fee, but send me the list of stocks now.” I didn’t bother to reply, only to receive this reminder: “I still haven’t received the list of stocks.” Later, I found out that this freeloader was regularly providing free stock tips in one of the investor forums!

The answer to the original question is: Many investors do. I think it is part of the human psyche that we get swayed by products that are offered ‘free’. That is why retailers periodically offer “Buy-1-get-1-free” deals to get rid of unsold or unfashionable or oversized/undersized stock. Shops tend to be overcrowded during such offers.

When it comes to stock advice, ‘free’ usually means ‘not good’. Investors need to appreciate that. If some one really knew which stocks will become multibaggers in future, he would not tell a soul and buy as many of those stocks he could afford before the stock market got wind of it. 

What if the stock market remains in a down trend for another year?

The Sensex and Nifty indices had touched their peaks one year back. Since then, both indices have been in down trends – neither falling a lot, nor rising much during counter-trend rallies. A gradual drift downwards that has all but sapped the bullish energy of small investors.

Several rounds of interest rate hikes by the RBI have failed to restrain rising inflation, but has started affecting economic growth. The high interest rates have led to postponing or cancelling of capital expenditure by companies, which in turn has affected the order books of capital goods makers, and engineering and construction companies.

The RBI had indicated the possibility of pausing the rate hikes if inflation begins to moderate. If the situation doesn’t improve within the next month or so, the RBI may be forced to hike the interest rate again.

Even if there is a pause in the rate hike, the already high rates are unlikely to be reduced immediately. Market sentiments do not turn bullish when interest rates are high and the GDP growth is slipping. It is quite possible that the Sensex and the Nifty may continue to trend downwards for another year.

However unlikely or pessimistic the above may sound, the path to success in stock market investing is to assess the surrounding environment at all times, and have strategies and plans in place. So, what can small investors do to prepare for another year of down trend in the stock indices?

The most important – and I can’t emphasise this more – is to have a financial plan, and based on it, an asset allocation plan. The queries I receive from small investors are mostly of these two types: “This stock is going up in a bear market – should I buy now or wait” or, “That stock has fallen a lot – should I wait longer or buy now”.

Hardly anyone asks me: “How do I make a financial plan” or, “How do I work out an asset allocation plan”. Without a plan, random buying and selling of stocks will lead to an unwieldy portfolio and very little returns.

Once plans are in place, a portfolio to suit the plans and the risk tolerance level of an individual can be built. A stock market in a down trend is the best time to build portfolios, because many good stocks are available at bargain prices.

What if you are one of those enlightened investors who already has plans and a well thought-out portfolio in place? Allow your portfolio to grow and prosper. How do you do that in a down trend? Mostly by not being overly aggressive. Within an overall down trend, individual stocks may perform better or worse. Use opportunities to book part profits or add to fundamentally strong stocks that have been beaten down.

Needless to say, whether to buy, sell or hold should be determined not by market fluctuations or gut feel, but by your asset allocation plan. When you book part profits, try to control the impulse of buying some thing right away. The high interest regime has its benefits in the form of higher bank fixed deposit rates and good returns from debt funds. Invest in them – as per your asset allocation plan.

Use the stock dividends that you receive at this time of the year to reinvest in your portfolio companies. Dividend reinvestment is like adding fertiliser to your plants. It helps them to grow better and faster.

Continue with your regular savings and systematic investment plans. There is a tendency of many small investors to stop investing when the markets are down. If you haven’t developed the skills to time the market (very few investors do), stick to your regular investments. Again, follow your asset allocation plan in a disciplined manner.

That is all there is to it. No magic formula will produce phenomenal returns in a down trending market. Just a boring, disciplined approach to planning, saving and investing for building wealth over the long term.

Why long-term investors should look at the big picture

With the Sensex and Nifty indices stuck within trading ranges for more than a month, small investors are in a quandary. What to do next? Two days of sharp bounce from a bottom, and the urge to jump in and buy is almost uncontrollable. Three days of correction from a resistance level, and every one is worried about a 2008-like crash.

Getting worried and disturbed about short-term index gyrations only increases your blood pressure and clouds your decision making. Times like these are true tests of your investment mettle. In life, unplanned action is some times better than planned inaction. But, for building wealth through successful investing in the stock market, you should practice the discipline of planned inaction.

The inaction refers only to buying and selling of stocks. Reading annual reports, books and preparing buy/sell lists are part of the daily ritual of  long-term investors. What then is the big picture referred to in the headline? I’m not an economist, but here is my take on what is happening around us.

Thanks to the Internet and FIIs, our stock market is fully integrated with global markets. All the nonsense about decoupling because of our strong domestic market is just that – nonsense. So, keep an eye on what is happening in global markets. To keep readers updated, I regularly post about stock indices in the US, Europe and Asia. If you are not reading those posts, ask yourself: Why not?

Europe is in quite a mess due to a unified currency that is not helping profligate nations - like Greece, Italy, Spain, Portugal - that are deep in debt and have very little capabilities (or even intentions) of repaying that debt. They neither can print their own currencies, nor can they devalue their currencies. The only options are that a financially stronger economy like Germany, and perhaps the IMF, will bail them out to stop them from defaulting. But that is postponing the problem – not solving it.

Many Indian companies – particularly IT services companies – switched their export focus from the USA to Europe post the dot.com crash in 2001. Some have built up significant businesses in Europe, including acquisition of European companies. The economic mess in the Eurozone is going to affect their bottom lines for the next few years.

China is a wild card. For years, they have been far ahead of India in building world-class infrastructure and an export-led high-growth economy. But with global economies slowing down, China is desperately trying to re-focus on their domestic market. There is strong suspicion about their reported growth figures, and that is reflected in their sliding stock market. If they start cutting back on their commodity purchases, which has been sustaining the global commodities market and shipping businesses, a big crash in global stock markets may follow.

The USA is not on the verge of collapse – like they were three years back. The situation is grim, but not hopeless. There will be a lot of pain before their economy eventually turns around. But thanks to two rounds of quantitative easing, and significant belt-tightening, US corporations are sitting on a lot of cash. They haven’t curtailed spending on existing IT services, and there are signs that they may be spending more on new services. The strengthening dollar will add to the bottom lines of IT services and export companies.

Our over-dependence on oil imports will further add to our balance of payments problem. The government had introduced several populist measures to help the rural poor. Subsidies on diesel, kerosene, fertilisers have added to the fiscal deficit. Rampant corruption and scams, as well as high inflation are keeping FIIs away. Their inflows partly help in reducing the deficit.

However, our GDP continues to grow. Not at 8-9% but more like 6-7%, which is much better than almost every one else except China. That pretty much rules out a 2008-like crash in the Indian stock market. But it could take a while before we see new highs on the Sensex and Nifty.

The sensible approach will be to cut out the daily noise emanating from the business TV channels, and concentrate on companies that have capable and trustworthy managements, and have records of several years of good performances through bull and bear cycles. If they produce goods or services that find buyers regardless of the state of the economy, so much the better. Companies that sell toothpaste, cigarettes, soaps and detergents, biscuits, life-saving drugs, drugs for chronic diseases, tractors, power tillers, tea and coffee will continue to do well.

Just remember that the stocks that don’t fall much during a down trend, don’t rise much during the subsequent up trend. The ones that fall more, tend to rise more. Of course, this ‘rule’ works only for well-managed companies.

Should investors keep a beady eye on the BDI (Baltic Dry Index)?

What makes successful investing in the stock market (or mutual funds) such a challenge (or, intellectually stimulating – depending on your mental makeup) is the wide variety of factors and indicators that you need to keep track of. The Baltic Dry Index (BDI) is one such indicator that many investors may not have a clue about.

What is the BDI, and why should investors keep a watchful eye on it? This is how wikipedia.com describes it:

The Baltic Dry Index (BDI) is a number issued daily by the London-based Baltic Exchange. … the index tracks worldwide international shipping prices of various dry bulk cargoes.

The index provides "an assessment of the price of moving the major raw materials by sea. Taking in 26 shipping routes measured on a timecharter and voyage basis, the index covers Handymax, Panamax, and Capesize dry bulk carriers carrying a range of commodities including coal, iron ore, and grain."

In plain English, the BDI gives an indication of international rates for transporting raw materials by sea in cargo ships of different sizes – based on supply and demand of commodities.

Why should stock or funds investors be interested in the current state of the BDI? Most economic indicators, like consumer spending, unemployment figures, housing starts are lagging indicators. That means, we get to assess the implications after the events have already occurred.

However, the BDI is a leading economic indicator because increasing demand for raw materials (which leads to higher shipping rates) is a signal of greater economic activity. That in turn, leads to growth and higher stock prices. Likewise, a fall in the BDI indicates declining demand for raw materials, leading to reducing economic growth and a likely slide in stock prices.

Unlike stock and commodity exchanges, where speculation is an important part of the overall activity and may camouflage the actual supply-demand equation, the BDI is free of any speculation since the index is based on shipping rates on various representative routes submitted by international shipbrokers who have actual cargo to transport.

Supply and demand of raw materials is not the only reason for changes in the BDI. Availability of cargo carriers, heavy traffic on certain routes, bad weather, price of oil can all contribute to higher shipping rates. Like all indicators, the BDI can’t be used in isolation.

Over the past year, the BDI has fluctuated between a high of about 2750 in Oct ‘10 and a low of about 1050 in Feb ‘11. It rose sharply from 1270 in Aug ‘11 to its current level of 1890. Is it indicating that the global economy may not be in the doldrums that many economists are suggesting?

Why small investors should emulate a convicted murderer in Texas

The Texas Department of Criminal Justice executes more condemned men than any other state in the USA. Traditionally, condemned men were granted a last request. Most death-row inmates chose to have an elaborate last meal before going to the ‘gallows’.

This practice has recently been stopped, thanks to convicted murderer Lawrence Russell Brewer – a member of a white supremacist gang who brutally murdered a black man by dragging him behind his truck for several kilometres before dumping his decapitated body near a cemetery.

Brewer ordered the following last meal before his execution:-

• Two fried chicken steaks with gravy and sliced onions
• A triple-patty bacon cheeseburger
• A cheese omelette with ground beef, tomatoes, onions, bell peppers and jalapeno peppers
• A bowl of fried okra with ketchup
• One pound of barbecued meat, accompanied by half a loaf of white bread
• Three fajitas
• A meat lover’s pizza
• A pint of Blue Bell ice cream
• A slab of peanut butter fudge with crushed peanuts
• Three root beers

No human being can possibly consume all that food in one sitting. In fact, when the meal arrived, Brewer refused to eat by saying he wasn’t hungry. He was deliberately manipulating the system. He ordered whatever he felt like, because he could – and then declined to eat it.

What does this bizarre tale have to do with small investors? The stock market displays a smorgasboard of alluring stocks from junk companies with questionable promoters that trap unwary small investors. After losing their shirts, small investors complain about ‘operators’ manipulating the system to deprive them of their savings.

Be a smart investor instead. Substitute each of the junk food items in Brewer’s last meal with companies like Cranes Software, Karuturi Global, Bartronics, Punj Lloyd, Suzlon, IVRCL, Delta Magnets, Reliance Communications, Kingfisher Airlines, Temptation Foods (!). Then ‘manipulate’ the system in your favour by refusing to buy any of their stocks. Only buy stocks of well-respected companies with proven managements at reasonable valuations, and you will never go wrong.

Fool’s Four stock investment strategy

Let me first assure readers that the Fool’s Four (or Foolish Four) stock investment strategy is neither foolish, nor is it meant to make fools out of investors. It is a ‘mechanical’ investment strategy that can be useful for those investors who haven’t yet developed their stock-picking skills, and have probably lost money chasing ‘cheap’ small-cap stocks.

The Fool’s Four strategy was designed by The Motley Fool investment group as a refinement to the Dogs of the Dow strategy. I had written about the Dogs of the Dow strategy in a post back in Apr ‘10. The strategy works just as well with Sensex stocks. (If you are a recent visitor to this blog, or have forgotten what I wrote more than a year back, you may want to read the earlier post first.) 

Since it is a variation of the Dogs of the Dow strategy, the Fool’s Four involves selection of four stocks from the Dow index (or Sensex) based on low price and high dividend yield. The dividend yield is calculated by dividing the actual dividend per share in Rupees (not the percentage dividends usually announced) by the current market price (CMP) of the share in Rupees.

The selection process involves calculating the square roots of the CMPs, and the dividend yields of each of the 30 Sensex (or Dow) stocks. Next, divide the dividend yield by the square root of the CMP to find a ratio for each stock. Then rank the 30 stocks based on a descending order of ratios (i.e. the stock with the highest ratio will have a rank of 1, and the stock with the lowest ratio will have a rank of 30).

If calculating the square roots of the CMPs is too much of a challenge, you can calculate the square of the dividend yield (multiply the dividend yield by itself) and divide it by the CMP. The ratios will be different, but the rankings will be the same.

Now comes the interesting part. Drop the stock with the rank of 1, and choose the next 4 (ranked 2 through 5). Buy equal Rupee (or Dollar) amounts of each of the short-listed four stocks, and hold them for a year. Why drop the stock with the number 1 rank? There is a good possibility that it may be in financial difficulties. Sensex (or Dow) stocks are supposed to be financially stable, but the odd JP Associates do get in trouble by being over-ambitious.

Is there any logic behind the Fool’s Four strategy, or is it just some foolish number crunching? Apparently, academic studies have proven that (a) high dividend yield leads to better market performance (which is the logic behind the Dogs of the Dow theory); and (b) stock price variations (or ‘beta’) is correlated with the square root of the price.

So, the Fool’s Four strategy gives slightly better results than the Dogs of the Dow (or Sensex) strategy. That doesn’t mean that all four stocks will beat the Sensex. The underperformer(s) should be replaced by stocks from the short-list of four selected next year. The Sensex-beaters can be retained.

(Note: Interested readers can do the exercise of selecting the four stocks from the Sensex that meets the above selection criteria. I’ll post their brief technical analysis once I receive your feedback. Then we can check back after one year and see how well the strategy works.)

How many shares of each company should I buy?

A common question vexing many small investors is how many shares of each company to buy. A young investor friend did quite a detailed analysis of a particular company, and took some inputs from me to fine-tune his analysis process.

After a few iterations to arrive at a proper valuation, he decided that the current price had enough ‘Margin of Safety’ and decided to buy the shares of the company. How many shares did he buy? 100. Nothing wrong with that. Small investors can’t always spare a lot of cash.

What happened next? Within a short time, the stock spurted on large volumes and doubled in price. My friend was left ruing the fact that he didn’t buy more shares even though he had spare cash. Shortly thereafter, the company announced a bonus issue, and the stock spurted even higher.

In spite of doing due diligence, a big money-making opportunity was lost because a sufficient quantity of shares were not purchased to start with. Such opportunities don’t come often. So, how do you decide what is a ‘sufficient quantity’?

In last Tueday’s post: How many stocks should I buy?, I had outlined how a Rs 5 lakh portfolio can be allocated to large caps, mid caps and small caps. The suggestion was: 8 large caps worth Rs 50,000 each, plus two mid caps and two small caps worth Rs 25,000 each.

While the money allocation to each category of stocks would automatically limit how many shares of each company you can buy, it won’t eliminate the risk factor. Different investors have different risk tolerance levels, and that should be built into the allocation.

Here is a simple example. Suppose you decide that the maximum loss you can afford in the large cap stocks is 5%, and 10% in the mid and small cap stocks. Your large cap allocation is Rs 50,000 to each of 8 companies. Your mid and small cap allocation is Rs 25,000 to each of 4 companies. A 5% loss in the large caps and a 10% loss in the mid and small caps would limit the loss to Rs 2500 per stock.

(If all your picks fail to perform and hit the respective stop-loss levels, your total loss will be limited to Rs 30,000; i.e. 6% of your Rs 5 Lakh portfolio.)

If you decide to buy a large cap with a current price of Rs 100, you can buy 500 shares with a Rs 5 stop-loss to ensure that you limit your loss to Rs 2500. What if a mid cap is trading at Rs 100? Should you buy 500 shares in that case?

Since mid caps tend to fluctuate more, you had chosen a 10% loss as your limit. That would mean buying a Rs 100 stock with a Rs 10 stop-loss. Buying 500 shares may incur a loss of Rs 5000 if your stop-loss is hit. So, you need to buy only 250 shares with a Rs 10 stop-loss.

The example is simplistic to make a point. You need to adjust stop-loss levels for each stock that you buy according to your comfort level and the beta value (i.e. the amount by which a stock fluctuates with respect to an index) of each stock.

How to use Covered Calls – a guest post

Last month, Nishit wrote about the Short Strangle strategy to make money in a sideways market. Not too much has changed since then. The Nifty is still trading within a range - not giving a clear direction.

Individual stocks in your portfolio may be going nowhere also. Can you generate some profits without selling your stocks and losing out on dividends or bonus issues? Covered Call writing may be just the strategy for you, suggests Nishit.

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We continue with our series of F&O with an article on Covered Calls. Covered Calls basically mean we already own an underlying asset and sell Calls.

The Wikipedia definition is:

A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. If the trader buys the underlying instrument at the same time as he sells the call, the strategy is often called a "buy-write" strategy. In equilibrium, the strategy has the same payoffs as writing a put option.

Let us take an example of Infosys. Infy has been rallying from 2700 to 2950 from the June Series. That’s roughly a rise of 10% for the past past 3-4 weeks. Logic states that if a stock rallies before results, then any good news is discounted in its price. Same logic if it falls before results. This is based on the principle that markets discount all news in advance.

Assuming I have Infy shares constituting 1 lot in F&O, which is 125 shares. If I had written 1 lot Rs 3000 strike price Option of Infy on Tuesday, then I would have got Tuesday’s price of 52. This would entail a premium inflow of Rs 6500 (=125x52).

I have 125 shares of Infy in my account. Now, if my trade goes right and Infy falls, then I get to keep the shares as well as pocket the premium of Rs 6500.

Now if Infy rises, till Rs 3000, I don’t pay anything. This is because Option strike price is Rs 3000. At Rs 3050, I have to pay Rs 50. My inflow is Rs 50 from writing, so no loss no profit.

Above Rs 3050, I start having to pay up. This also means that when market price was Rs 2950, I was covered till Rs 3050 for losses and above that, I sell my shares which I hold and pocket the money. Suppose, Infy hits Rs 3100, then I sell off at a rally of Rs 350 from the bottom which translates to 13% gain in a span of 4 weeks.

A stock like Infy moves max 20% in a year in a range. Like from Aug ’10 to Jan ’11, Infy moved from Rs 2700 to Rs 3500. Not a bad deal.

This strategy is recommended for Long Term Investors who have shares in their demat accounts and want to earn some money on the side, without losing out on dividends or bonus.

Before entering any trade, one should have a clear idea of reward, risk and max loss and max profit.

Note: The figures at some times may be indicative or rounded off for example’s sake. The idea of this article is to try and explain the fundamental principle. True students of Option Strategies should try and grasp the basic principle. The strategy works best for stocks in which you are long-term bullish, but which may not be moving much in the near term.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

How many stocks should I buy?

From the emails I receive from readers and newsletter subscribers, this is a common question faced by many small investors. Due to limited resources, investors tend to swing from one end of the buying pendulum to the other. They either buy 30 shares of a fundamentally strong stock trading at Rs 500; or, they buy 500 shares of some unknown small-cap trading at Rs 30.

Both can be counterproductive for the growth of your portfolio. With the costlier stock, a sudden spurt to Rs 600 may tempt you to sell out quickly and miss a bigger profit opportunity. The alternative strategy of booking partial profits and holding the rest with a trailing stop-loss may not work too well with only 30 shares to play with.

For the less expensive stock, a 20% gain from 30 to 36 may not seem enough to do any profit booking. So you hold on with the hope of selling only if the stock reaches 50 – which it may never do. In fact, the cheaper stock is more likely to drop to 15.

What is the solution? Firstly, you need a decent amount of capital to build a portfolio of individual stocks. I recommend a minimum of Rs 5 lakhs – preferably Rs 10 lakhs. What if you have only 1 or 2 lakhs? You may be better off investing in mutual funds and fixed income instruments to build up your capital.

What if you do have Rs 5 lakhs? How do you decide how many stocks to buy? The thumb rule in buying individual stocks is: More is not merrier. Keeping regular track of any more than 10-12 stocks can become a full-time activity. You have to remain informed about the overall economy – local and global, individual sectors to which your stocks belong, quarterly performance of individual stocks as well as news flows about them; read Annual Reports; check if dividends are getting credited; apply for rights shares, and a myriad other things.

If you settle on 12 stocks for your portfolio, how will you allocate to large, medium and small-caps? A thumb rule for getting steady returns, protecting downside during bear attacks, plus having a growth ‘kicker’ is to allocate 80% of your capital into stalwart large-caps, and 20% to good mid-caps and small-caps.

How many stocks in each category? Say, 8 large-caps, 2 mid-caps and 2 small-caps. Allocating Rs 50000 for each large-cap, and Rs 25000 to each mid-cap and small-cap stock will complete your portfolio. This is a suggested portfolio. You can tweak it to suit your own style and risk tolerance.

Once you limit yourself in terms of the number of stocks and the allocation of capital to each stock, a funny thing will happen. You will be forced to be very selective about the stocks you pick. That will, in turn, make you more disciplined about choosing the very best stocks – and waiting to buy them only after a significant price correction.

The same Rs 500 stock mentioned earlier was probably trading at Rs 200 two years back, and may drop to 350 after the next correction. Instead of buying 30 shares now, buy only 10 (to help you to track it regularly). When (and if) it drops to 350, buy 130. You will end up with 140 shares and complete your Rs 50000 allocation to the stock.

Related Posts

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Announcing re-opening of paid subscriptions to my Monthly Investment Newsletter

I am pleased to announce the re-opening of paid subscriptions to my monthly investment newsletter for a 3 weeks period from July 1-21, 2011. Only a limited number of subscriptions will be offered – strictly on a first-come first-served basis – to enable me to provide personalised attention and guidance to each subscriber.

If you are interested in subscribing, please send an email to: mobugobu@yahoo.com at the earliest for details. Your email address will be kept in confidence.

The newsletter has completed 18 issues. The past few months have been a challenging and humbling experience for me. It was a challenge to find stocks with growth potential at reasonable prices while the Sensex kept reaching new 52 week highs through most of 2010. The prolonged 8 months long corrective phase since Nov ‘10 has been humbling because many stocks have not performed up to expectations, and yet subscribers have kept faith in my stock picking abilities.

Those who have been following my blog posts regularly know by now what kind of stocks I like, and what type of stocks I avoid. The guiding principle has been to choose well-managed, financially sound companies that give steady (rather than spectacular) returns and have growth prospects.

Non-subscribers may be interested to know how the recommended stocks have fared. Without revealing the names of the stocks (it won’t be fair to my subscribers to do so), here is a brief results table with prices on recommended dates, subsequent high and low prices, and gains/(loss) in percentage as on July 1 ‘11:

Stock	Date	Price	High	Low	Close	Gain/(Loss)
1a	Jan ‘10	206	399	195	374	81.5
1b	Jan ‘10	131	316	120	185	41.2
2	Feb ‘10	78	94	55	65	(16.7)
3	Mar ‘10	178	305	168	236	32.6
4	Apr ‘10	82	116	61	73	(11)
5	May ‘10	171	247	85	125	(26.9)
6	Jun ‘10	101	156	98	127	25.7
7	Jul ‘10	285	305	213	230	(19.3)
8	Aug ‘10	274	434	264	421	53.6
9	Sep ‘10	130	141	95	123	(5.4)
10	Oct ‘10	120	135	89	108	(10)
11	Nov ‘10	101	150	55	71	(29.7)
12	Dec ‘10	53	59	37	48	(9.4)
13	Jan ‘11	91	122	90	116	27.5
14	Feb ‘11	294	329	257	295	0.03
15	Mar ‘11	444	502	405	480	8.1
16	Apr ‘11	107	117	95	105	(1.9)
17	May ‘11	275	280	250	277	0.07

All 18 stocks are small or mid-caps, picked for long-term investment of minimum 2 to 3 years. The fact that some of them are showing decent gains – even after falling from their highs - is a testimony to their underlying strength. Note that 9 of the 18 stocks are showing losses. That gives me a ‘hit ratio’ of only 50% – which is no better than tossing a coin.

But have a look at the ‘High’ column. One stock more than doubled, five gained 50% and every single stock moved up after my recommendations. In a 2-3 year time frame, I expect most of the laggards to make up the slack.

What is important to appreciate is that these stocks were not ‘cheap’ and had already run up quite a bit when they were recommended. The lesson is that even near 52 week highs and subsequent corrective phases of the Sensex, there are stocks available that can provide decent returns. Since the recommended stocks are all regular dividend payers, the actual returns will be higher.

If you need help in selecting good stocks in uncertain times, all you need to do is subscribe to my Monthly Investment Newsletter. Send me an email (at mobugobu@yahoo.com) soon – subscriptions will close on July 21, 2011.

How to choose stocks for trading

Regular readers of this blog need not feel let down by the subject of today’s post. I am a firm proponent of generating wealth through long-term investment by carefully choosing stocks, using both fundamental and technical analysis.

Though I occasionally indulge in longer-term trading in cyclical and FMCG stocks, intra-day or short-term trading remains a strict no-no. The odds for success are too low and the scales are heavily tipped towards the professional traders.

So, why write a post about how to choose stocks for trading? Last week, I had written a post explaining why good investment stocks may not be good trading stocks – and vice versa. The chart patterns of Titan and Reliance were used for comparison. The concluding statement in the post was: “Whether you are a trader, or investor, or both – it improves your chances of making big money if you do your homework in selecting stocks.”

I have already written a series of three posts on how to pick stocks for investment. If you haven’t read those posts, I would strongly recommend that you do so. But because of my antipathy towards trading, I had refrained from writing about choosing stocks for trading.

Why then the sudden change of heart? Let me explain. I have been working on this theory about suicides: If any one is hell-bent on committing it, it should be my duty to guide that person towards the least painful method.

If some one is planning to commit financial suicide (which I reckon a few readers may already have attempted), then it is also my duty to guide them towards the process that may be less painful.

Enough preamble. Now let us get down to brass tacks. Though any stock can be chosen for trading – regardless of its fundamentals – it helps to have a plan and some background knowledge.

High value stalwart stocks typically do not fall too much during down trends, neither do they rise much during up trends. That makes them good picks for stability in one’s long-term portfolio. Not so great for trading.

Penny stocks (i.e. those trading below Rs 10) tend to be irregularly and thinly traded most of the time. Only a few hundred shares being bought and sold can change the stock’s price by a significant amount. While that may appear attractive for trading, being able to buy or sell any decent quantity when you want to can pose a problem.

Mid-priced stocks – say those trading between Rs 30 – 80 – may be the best bets for trading success. Of course, such stocks should trade regularly and with decent volumes. Make a list of such stocks, and start studying their chart patterns. Short-list the ones that are most volatile (i.e. the ones that give big swings from high to low in short periods of time).

Even after going through the above exercise, you may have a short-list that is not so short. Checking the charts of more than 20 or 25 stocks on a regular basis can be a daunting task unless you are doing it full-time. Use the ‘Circle of Competence’ concept to drill down to about 20 stocks, and then spend a period of ‘paper trading’ to fine tune your short-list.

Drop the ones where your paper trades turn sour. Add a few more from the original short-list till you are comfortable with the final choice of the stocks you would like to trade.

Happy trading! (Don’t blame me if you get killed – you are the one attempting to commit financial suicide.)

Why good investment stocks may not be good trading stocks – and vice versa

The hundreds of stocks that are regularly traded in the BSE and NSE can be broadly separated into three groups – stocks that are good for investment; stocks that are good for trading; and, stocks that are plain junk and should not be touched.

Regular readers of this blog know that I’m neither a great fan of short-term or day trading, nor do I encourage small investors to do so. The only person that gets rich is the broker. No wonder various internet investment groups are full of brokers constantly giving short-term buy and sell calls.

However, it is a fact of life that small investors fall prey to the lure of making quick and easy money, and frequent investment groups and web sites that offer ‘free 100% sure-shot short-term calls’ as a short-cut to untold riches.

I was taken aback when I read read about a short-term sell call on Titan Industries. If the stock falls below a certain level, then it could fall by a whopping 2% more! However, if it rises above a certain level, then the uptrend will resume. A quick look at Titan’s 2 years closing chart pattern shows a more than 50% gain from its Feb ‘11 low, followed by a 3% correction that must have triggered the call.

Titan has gained 300% in 2 years, providing fabulous returns to long-term holders. Any sensible broker would have given a ‘buy the dip’ call instead of a short-term sell call for a paltry 2% profit.

Put it down to ignorance, or inexperience, or both. Many traders believe in the myth that all fundamentals are ‘in the price’ – so it is a waste of time to spend hours in stock analysis.

A trader, if he wants to make money consistently, has to spend hours studying technical charts to try and get into trades that will make huge profits - to cover up many small losses that are part of a trader’s life. Even a novice can take a look at Titan’s chart and conclude that a trade on the long side will be more profitable.

It is precisely because Titan is such a great stock for long-term buy-and-hold investment that it is not a good stock for short-term trading. It doesn’t provide enough wild swings to get in and out with big profits.

Is the vice versa true – that good trading stocks do not make good investment stocks? What is a good trading stock? For the answers to both questions, take a look at the 2 years closing chart pattern of Reliance.

Thanks to its massive market capitalisation, the Reliance stock finds a place in most large-cap and diversified equity funds as an investment-grade stock. But on 2 years, 1 year, 6 months and 3 months time frames, it has provided negative returns.

The rounding-top bearish pattern of the 200 day EMA, and the 50 day EMA trading below the 200 day EMA for the past five months are clear indications that the bears are getting the upper hand.

Experienced traders probably got seriously rich just by trading Reliance over the past couple of years. Look at the frequent and large price swings – just the kind of chart that should make traders rub their hands in glee.

The moral of the story? Whether you are a trader, or investor, or both – it improves your chances of making big money if you do your homework in selecting stocks.

Why small investors should avoid ‘cheap’ stocks

There are several reasons why small investors should avoid ‘cheap’ stocks, and I will take them up one by one. Before that, one must understand what is meant by ‘cheap’ stock.

Investopedia.com has the following definition:

“The illegal practice of issuing stock options at artificially low prices shortly before an initial public offering. Often underwriters will require a company to have more qualified management before they can go public. They attract these qualified individuals by giving options with a low exercise price.”

This was a practice which was prevalent prior to and during the dot.com boom in the USA, and is not unheard of in India. While it can lead to significant profits, the average small investor won’t be able to participate - unless his uncle or friend’s father was the promoter of the company. If a company is trying to sell its stock through bulk SMS and email messages at a lower price than its forthcoming IPO price, chances are that it is a ‘dud’ company and best avoided.

Then there are those companies that were the apple of investor’s eyes during the previous bull market, and reached stratospheric levels just before the crash in Jan 2008. Real estate stocks were at the forefront, followed by the stocks with the word ‘infrastructure’ in their name. Most of these apples had rotten cores. They have not only become cheap stocks, but continue to get cheaper by the day. Don’t go anywhere near them.

There are cheap stocks which are also called ‘penny stocks’ because they trade below Rs 10. Most of them are unknown, fraud companies who have no business and no intention of doing any business. Occasionally they boost up their share price from Rs 3 to Rs 8 by planting fake stories in the media about the great opportunity for investors once they dismantle the fourth rate defunct plant that they have bought in Uzbekistan or Burkina Faso and reinstall the plant in Jhumri Tilaiya. Avoid such stocks like the plague.

Some cheap stocks may appear cheap, but are not. A Re 1 face-value stock trading at Rs 15 is equivalent to a Rs 10 stock trading at Rs 150. A Rs 10 face-value stock trading at Rs 15 may not be cheap either, if it belongs to a loss-making company, or one that is trading at a P/E of 80 or 100. Stay away from such stocks.

What about stocks that appear relatively cheap with P/E ratios below 15 that generate strong cash flows from operations, have low debt/equity ratio and double-digit profit margins? Ah-ha, now we are talking. I just love to dig and find such stocks. They are the ones that will give a nice boost to your stock portfolio’s performance.

What small investors can learn from my trip to the bank

Thanks to the technological innovations of debit cards and credit cards, my trips to the bank have become few and far between. So, on the rare occasions that I do visit a bank, I’m pleased to see lots of eager, young faces looking busy and ready with a smiling ‘Can I help you, Sir?’ welcome.

The initial good feeling soon turns to exasperation. I had gone to get a copy of the account statement for March ‘11 that I had misplaced. A pretty young lady said it would only take a couple of minutes, and would I mind the wait? Not at all, I assured her. That is when things started going wrong.

First, she wanted to know my account number. Since I didn’t remember it, I gave her the April ‘11 statement copy. My daughter’s name appeared as the holder. So, the next question – without even checking that I was the second holder – was, who do you bank with? I mentioned the name of two competing private sector banks.

She had taken a look at the account balance, and came up with: Can we help you with your investments? I said, no thanks. By this time, a bright-looking male colleague came to inform her that the printer was down and the statement will be couriered to me. But he had overheard our conversation and decided to jump into the fray with: Have you thought about a SIP in a mutual fund?

I was already feeling irritated because the trip to the bank had been a waste of time. So I mentioned my preference for investing in stocks and asked him whether he had started a SIP. He proudly announced that he invested 20000 in a SIP every month, and explained how his holding cost will average out over the ups and downs of the market.

Had he thought it through, or was he merely repeating what he had been taught? It was his turn to be irritated. Simple arithmetic, he scoffed. When the market goes up, he gets fewer units, but when the market falls he gets more – so it averages out!

Had he done the arithmetic with real data? Did he know that bull markets tend to last 3 to 4 times longer than bear markets? Therefore his average holding cost is likely to rise over time? Now he didn’t look so confident. So he tried a different tack – not willing to pass up an opportunity to ‘cross-sell’.

Had I thought about investing in a private equity fund? I told him that SIPs and private equity funds are thought up by fund managers to help the fund and their own pockets. They don’t benefit the investor to the same extent.

He made another effort: A competing bank has made a ton of money by floating three private equity funds. I responded with: Does it prove that your fund will make money? Now he played his trump card: How do I make money when the market is down – like now?

I explained that investing is not a job where one had to make money every day. If one invests in good dividend paying stocks, like TISCO or ITC, then one can earn money whether the market is up or down. ‘Every one knows ITC pays good dividends’ – was his parting shot. So how many ITC shares did he own? He had accumulated 70 shares. Instead of his SIP, why didn’t he buy 100 shares of ITC every month? No answer this time – end of debate.

The moral of the story is: Regardless of whether you concur with my antipathy towards SIPs or not, always question investing strategies – whether you have thought it up yourself, or received advice from anyone.

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How small investors can widen their Circle of Competence

Warren Buffett is a strong believer of the Circle of Competence concept. If a company or business doesn’t fall within his Circle of Competence, he won’t touch it. He famously avoided buying into any high-tech company in the 1990s – when every one and his brother-in-law were investing in dot.com companies. He didn’t understand how high-tech companies were making money, and whether they had sustainable businesses. He missed the boom – and the inevitable bust that followed.

Warren Buffett is one of a kind. You and I will never be able to match his skill and wisdom in investing. That doesn’t mean we shouldn’t follow some of his money-making principles. What if our Circle of Competence is too limited? Is there a way to widen the Circle?

Let me give you the bad news first. You can’t widen your Circle of Competence in a hurry. It is a process that will take a lot of time and effort. The good news is that the process is not difficult or complicated. It takes patience, perseverance, and a plan.

First make a short-list of all the knowledgeable people you know. The list isn’t likely to be a long one if you are looking for people with real knowledge. Not some one who knows how many hundreds Tendulkar scored before the age of 25, or the exact locations of the seven wonders of the world. But some one who knows about the economy, business and industry.

Next, figure out how you can meet such people without imposing too much on their time and patience. May be he is a friend’s father or your wife’s uncle. If you inform them in advance that you want to meet them, and the reasons for the meeting, knowledgeable people will be more than happy to share some of their experiences.

Don’t know anyone knowledgeable enough? Join discussion forums and investment groups. There are many in cyberspace. Each group or forum will have a few knowledgeable members. Try and pick their brains.

Going to a family wedding or a party? Don’t just waste your time eating and drinking and being merry. Introduce yourself to people you don’t know, and find out about what they do. If you show genuine interest in their activities, they will give you a lot of information that you won’t find in TV channels or pink papers.

Carry on this process for some time, and you will be amazed at how much wider your Circle of Competence can become. Then, have the discipline to stick to your Circle of Competence when choosing stocks to buy. That will prevent you from getting badly stuck in the shares of a company that you really know nothing about. Like Suzlon, or Punj Lloyd, or Bartronics.

Related Post

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Stock Index Chart Patterns - BSE Sectoral Indices, May 27, '11

In last month’s analysis of the BSE Sectoral indices, I had looked at the weekly bar chart patterns from Mar ‘09 onwards. This month, I have attached the one year bar chart patterns once again to get a clearer view of the near term situation.

BSE Auto Index

BSE Auto index is technically still in a bull market – despite the dip below the 200 day EMA during Feb and Mar ‘11. The index received good support from the 8115 level and bounced up to prevent the ‘death cross’ of the 50 day EMA below the 200 day EMA. However, the technical indicators are looking bearish and the index is struggling to stay above its long-term moving average. The down trend from the Nov ‘10 top is intact. Hold.

BSE Bankex

BSE Bankex has once again slipped below the 200 day EMA and the ‘death cross’ looks imminent. The index has turned up before reaching its support level of 11330, but the technical indicators are not holding out much bullish hopes. The 7 months long down trend is yet to be reversed. Hold.

BSE Capital Goods Index

The down trend in the BSE Capital Goods index has turned into a bear market, confirmed by the ‘death cross’ in Jan ‘11. The recent rally faced strong resistance from the falling 200 day EMA. The technical indicators are mildly bullish. Buy only on a clear break above the 200 day EMA.

BSE Consumer Durables Index

BSE Consumer Durables index has been one of the better performers and is in a bull market. It recovered quickly from the drop below the 200 day EMA in Feb ‘11, but the up move faced resistance from the 6600 level. The index is making a saucer-shaped bullish pattern. Add on a break above 6600.

BSE FMCG Index

BSE FMCG index has been the star performer during the past year, and has outperformed the Sensex in the past 7 months. It formed a bearish triple-top pattern and dropped below the 200 day EMA in Feb ‘11. A magnificient recovery took the index to a new high this month. Negative divergences in all four technical indicators has stalled the rally. Any dips can be used to add. 

BSE Healthcare Index

BSE Healthcare index has recovered from a 2 months stay below the 200 day EMA, but the rally has lost momentum. Technically, the index is in a bull market but is well below its Jan ‘11 top. Hold.

BSE IT Index

BSE IT index performed sensationally till its peak in Jan ‘11. The subsequent correction bounced up strongly from the rising 200 day EMA, but failed to test its Jan ‘11 top. This time, the index has dropped below the 200 day EMA, and the ‘death cross’ will confirm a bear market. Technical indicators are bearish. Hold.

BSE Metal Index

BSE Metal index is in a bear market, despite a valiant effort in Apr ‘11 to reverse the trend. The technical indicators are hinting at a recovery, but the index has dropped well below the 200 day EMA. Buy only on a convincing move above the Apr ‘11 top. Avoid till then.

BSE Oil & Gas Index

BSE Oil & Gas index is a clear example of how populist government policies and meddling can push a good sector into a bear market. The so-so performance of the largest private sector player, Reliance, has also not helped the cause of the index. The index has recovered some what from oversold conditions, but has a long way to go. Avoid.

BSE Power Index

BSE Power index has been in a down trend since Oct ‘10 and sliding deeper into bear territory. The technical indicators are bearish. Avoid.

BSE Realty Index

BSE Realty index is also deep inside a bear market, with little hope of any recovery soon. Avoid.

Five sectoral indices are in bear markets. Even good performers like the BSE Bankex and BSE IT index are struggling to escape from strong bear grips. That doesn’t mean all the stocks in these sectors should be avoided. I have been posting about stocks comprising different sectoral indices – and a handful of them are bucking the trend. Those are the stocks to watch.

What to do when stock prices fall?

Most small investors – particularly the recent entrants to the stock market – are ‘bulls’. That means, they buy a stock at a certain price and expect the price to quickly move higher so that they can sell and make a tidy profit without going through Step 1 (see below).

The idea is not entirely wrong. Being a bull is usually more ‘fun’. When you buy a stock and it starts to rise rapidly, you tend to feel elated and proud that you have made a smart choice. But it is no fun at all when the stock you have bought recently suddenly turns around for no rhyme or reason, and starts falling like a stone.

Your elation vanishes into thin air. Your pride takes a beating. You can’t confide to friends or family because they will either laugh at you or scold you for being a greedy gambler. You start losing sleep and look for ways to recover from the situation.

One of the worst things to do is to buy more as the stock price keeps falling. Your ‘average’ price goes down, but your losses keep on increasing. You eventually lose hope, and either sell when the stock price is near its bottom, or become a reluctant long-term investor.

So, what was wrong in being a bull? Forgetting that there is always another animal called a ‘bear’ in the stock market. While bulls are strong and can sweep aside all resistances when they are excited and charging, they are basically peaceful vegetarians.

Bears, on the other hand, are vicious and cunning meat-eating predators. In the stock market, a handful of professional bears make mincemeat out of the hordes of peaceful small investor bulls. What helps the bears is that they only need to pay a margin amount for shorting a stock which they may not even own. Then they square off the deal at a lower price and pocket the profit.

How do you avoid being decimated by bears? Follow three simple steps:

1. Do your homework before buying a stock. Is it fundamentally strong? Does the company have growth opportunities? Does the business model generate adequate cash from operations? What is the reputation and track record of the promoters?

Learn about some basic ratios like P/E, P/BV, Debt/Equity, Market Cap/Sales, Return on Assets. (Most of these concepts have been covered in different blog posts.)

2. Buy any stock with an adequate Margin of Safety

3. In spite of doing your home work and buying with a Margin of Safety, a stock’s price may start to fall after you buy it. Avoid a big loss by taking a small one. Learn how to set a stop-loss.

That was the long answer. The short answer is: Sell, and sit on the cash. Go to Step 1 above. Don’t go to Step 2 before becoming thoroughly conversant with Step 1.

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