Spreading some good cheer in a gloom and doom market

You haven’t misread the title. I do intend to spread some good cheer on a day when the Nifty fell by nearly 100 points and the Sensex tanked by more than 300 points. Many large-cap stocks are sliding, which means the correction in the indices are not yet over. 

Many readers may think – specially after reading my recent posts and comments - that I am a perennial bear who advises caution during bull phases and staying away during bear phases. They won’t be too far off the mark in their assessment. Over the past five years, I have been a net seller in the markets.

But that doesn’t make me a bear – more a realist. After 25 years of investing in the stock market, I have learned from experience that a bullish stance causes more losses than a bearish stance. Warren Buffett’s two investment rules should always be remembered:

• Rule No. 1: Never lose money
• Rule No. 2: Never forget Rule No. 1

The trick to long-term wealth building is not to try and make a lot of money in a short time, but to ensure that your losses are taken quickly and kept to a minimum (through appropriate use of stop-loss levels) and profits should be allowed to run.

OK, enough pontification for today. Now, to the subject matter of today’s post. In a recent article in MoneyWeek,  author Cris Sholto Heaton made the following comments that may sound like music to the ears of small investors:

• India's inflation is too high. That's been caused by growth running too rapidly for the amount of spare capacity in the economy. So if you want to bring prices under control, you're going to have to curb growth for a bit.
• Ultimately, if EM governments are willing to act to slow their growth at this stage of the cycle, it's healthier for their economies in the long run.
• This is the normal cycle. Growth peaks amid rising inflation, slows as interest rates rise, and then can begin to pick up again as the central bank loosens policy.
• EM policymakers are likely to be able to declare inflation beaten for this cycle over the next three months or so. Most can then begin loosening policy. And as long as Europe avoids the very worst outcomes (a bad outcome is a foregone conclusion at this stage), EM growth is likely to pick up again within the year.
• It's been a tough five years for EMs. We've seen the global financial crisis and the eurozone crisis, both of which have encouraged investors to flee to safer assets. Yet over this period, the MSCI Asia ex-Japan is still handily ahead of the S&P 500.
• EMs wobble more when inflation gets high and interest rates start to bite. And they certainly sell off harder during a panic. That's what we've seen in 2011.
• But the other side of this is that they perform much better when growth is strong and they're likely to do better over the course of the economic cycle. So while the news is unlikely to get any cheerier in the next few months, it should be setting EM investors up for a much better 2012-2013.

I thoroughly endorse the authors views.

Gold and Silver Chart Patterns: up, up and away?

In an update of the technical chart patterns of gold and silver posted two weeks back, I had mentioned about the possibility of a sharp correction in gold’s price due to the extremely overbought condition, and advised investors to use the dip to buy. Silver’s price was expected to pull back a bit after a quick rise above the 14 day SMA, and provide a good buying opportunity.

Gold Chart Pattern

A sharp correction was expected – and what a sharp correction it was! Gold’s price was shaved off by almost $200 in the space of two days of trading. The 14 day SMA was easily breached and the price headed down towards the 30 day SMA. The bounce back was equally sharp.

Before the overbought condition could be properly rectified, gold’s price shot up above the $1900 mark. The volatility continues in today’s trading. Price touched a new peak of $1920, only to correct by more than $50 within a couple of hours! At the time of writing this post, gold’s price seems to be stabilising around $1900.

Such volatility is a sign of growing uncertainty, probably caused by the bleak outlook of the US and Eurozone economies. Uncertainty usually precedes a correction. That doesn’t mean that gold’s price may not rise some more. But one should be very cautious about entering near all-time highs – regardless of what you may hear or read.

Technically, the ever widening distance between the 14 day SMA as well as the 30 day SMA (not shown in the chart above) and the 200 day SMA is a harbinger of a big price meltdown. If you are invested in gold, maintain a strict stop-loss at 1820 – which is the level of the 14 day SMA.

Regular readers know that I am not a fan of buying gold because it provides no returns. If you are interested about a view based on historical analysis of gold and stock investment performance, read this article.

Silver Chart Pattern

Silver’s price chart shows a short and sharp correction, from $44 to $40, and a quick dip below the 14 day SMA. A pull back to $42 was expected. It provided a good entry opportunity. The quick recovery did not affect the upward momentum of the 14 day SMA or the 200 day SMA. The bull market in silver is intact, which is confirmed by the bullish pattern of rising tops and rising bottoms.

During today’s trading, silver’s price faced a sharp $2 drop before stabilising near the $42.50 mark. Technically, there isn’t any immediate threat of a big price correction. Dips can be used to accumulate. A convincing move above $49 will restore control to the bulls.

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 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

Learn the Art of Partial Profit Booking

Why building a stock portfolio is like buying a car

Some strategies about selling stocks

Why discuss stock selling strategies just when the Sensex is showing some signs of life after an 8 months long corrective move? Isn’t this a good time to buy and make some money?

The answer depends on what type of investor you are. If you want to play the momentum in the short-term, by all means buy and book profits after a gain of 3 or 5 points. May be even 8 or 10 points. Which isn’t bad at all – if you are trading thousands of shares. Such a strategy can be followed at any time.

But many small investors don’t have big money at their disposal. They can buy 200 or 500 shares at a time (I’m not talking about penny stocks here). A 5 or 10 point gain is neither here nor there – compared to the risks involved. May be this isn’t such a great time to buy after all – since the index is just about 10% below its all-time high.

Instead of having an ad-hoc hit-and-miss strategy, have a plan. For buying, holding and selling. The ‘Margin of Safety’ concept works well for buying. P/E bands work well too – for buying, holding and selling. I prefer to use an asset allocation plan for timing buy-sell-hold decisions.

Today, I want to discuss a few selling strategies. Before you buy any stock, decide on a selling plan – based on your risk tolerance, time horizon and individual preference. As a long-term investor, I prefer to have a three years time horizon for any stock to perform. You can just as well choose a one year or two years time frame. Anything less than a year, and you will be treading the fine line between an investor and a speculator.

Once you decide on a time frame, pick a realistic price point. 100% gain in 1 year may happen once or twice, but is not a realistic goal. But a 50% gain in two years, or a 100% gain in three years may be more achievable. When the price target is reached, it is best to sell out entirely. But if you feel that more upside is left, book partial profits, and hold on to the rest with a trailing stop-loss. If the price target is not reached, don’t hold on with the hope that it will be reached ‘some day’. Just sell.

If by partial profit booking you have withdrawn your original investment, don’t ever think that the balance holding is ‘free’. It isn’t. It has an opportunity cost. If the market dives and your balance holdings drop by 50%, you have lost real money. A trailing stop-loss will save you from such a calamity.

Supposing you have a two years time frame with a 50% appreciation target. After six months, the stock suddenly starts to flare up and gains 50%. What should you do? Wait for your two years time frame, or sell now? Sudden flare-ups in stock prices occur for different reasons - insider buying, some company-specific news that you may not have heard yet, a fundamental change in the sector, a merger or acquisition.

Why bother with reasons? If your target is reached, sell – even if it means paying short-term capital gains tax. After all, tax is paid from profits – so you are still ahead.

So far, I have discussed selling strategies when your stock is in profit. What if you buy a stock and it keeps falling down? Have a strict selling strategy – a 3% or a 8% or a 15% stop-loss, depending on the type of stock and the planned period of holding. Have the discipline to sell as soon as the stop-loss is hit on a closing basis.

Learn to be unemotional and unexcited about your buy-sell-hold decisions. Treat them like any monetary transaction – like buying a cup of coffee or getting a hair-cut.

Related Posts

What exactly is the Margin of Safety?

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Gold and Silver Chart Patterns: an update

In my previous post on Gold and Silver Chart Patterns, I had mentioned about a pair-trading opportunity. Going through that post, I realised that instead of recommending 'long gold, short silver', I had written the exact opposite.

For any one who had read through the entire post, it would have been clear that I was bullish about the gold chart and bearish about the silver chart. However, as a penance for the error, I'm going to refrain from making any more trading recommendations.

Gold Chart Pattern 

Gold's price dipped below the rising 14 day SMA, but was well supported by the 30 day SMA. By Fri. Jun 17 '11, gold's price managed to close above the 14 day SMA - indicating that investors are using all dips to buy.

As long as the recent high of 1565.70 - touched in Apr '11 - is not surpassed, the bears will try to make life difficult for the bulls. But may not be for long. A bullish ascending triangle appears to be forming on the gold chart, from which a likely upward break out can easily take gold's price past the 1600 mark.

Stay invested with a trailing stop-loss. Buy on a break out above 1550.

Silver Chart Pattern 

Silver's price chart continues its consolidation within a symmetrical triangle, and is now trading below the 14 day, 30 day and 60 day SMAs. Triangles tend to be unreliable, but are usually continuation patterns. Since silver's price entered the triangle from above, it is likely to break below the triangle and test support from the still rising 200 day SMA.
Buy if there is a sharp upward bounce from the 200 day SMA.

Gold & Silver Chart Patterns: pair trading opportunity?

Regular readers of this blog know that I’m not a great fan of investing in precious metals. Neither do I trade for the short-term, nor do I recommend that small investors should indulge in trading. But sometimes an opportunity stares you in the face – as the one year gold and silver closing chart patterns seem to be doing now.

Gold Chart Pattern

The technical headwinds that the gold chart was facing last month led to a decent correction below the 14 day SMA. Such corrections restore the health of the bull market and provide good entry points.

Isn’t gold’s price near an all-time high, and shouldn’t one be cautious? The current investor interest in gold has been largely due to the weaknesses in the dollar and the euro. The currency weaknesses aren’t going away any time soon. Gold’s bull market is likely to test and surpass its recent peak of 1565.70.

But it is a good idea to be careful – more so because gold’s price and its 14 day SMA have both risen far away from the rising 200 day SMA. A deeper correction may be around the corner. Stay invested with a trailing stop-loss.

Silver Chart Pattern

The technical headwinds turned into a full-blown hurricane in silver’s chart pattern. A 33% correction from the peak of 48.70 to a trough of 32.50 has shaken off the speculators.

Silver’s price has been consolidating within a triangle pattern and has edged above the 14 day SMA, but remains below the falling 30 day SMA. The possibility of a breakdown below the previous low and a test of support from the rising 200 day SMA can’t be ruled out.

The pair trade? Long silver, short gold. But remember – I have no skin in this game!

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.

Related Posts

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Stock market quiz for new investors – a discussion

Before getting into a detailed explanation of last week’s stock market quiz, I would like to specially thank all the readers who attempted answers. Answering questions in an open forum requires a certain amount of courage. There is always a fear that you may get the answers ‘wrong’.

That is why the answer options were provided in a way that apart from a few obvious ‘wrong’ answers, readers could choose from several ‘right’ answers. This is an important point for new investors to appreciate. If you are going to be successful stock investors, you need to have your own strategies and tactics. If a system or style works for you, it is a good system. Otherwise, you need to tweak or change it to make it work.

Let me provide the answers that I would have chosen – as a conservative, risk-averse, long-term investor:

1 (d); 2 (b); 3 (d); 4 (d); 5 (e), and I will explain why. That doesn’t mean that my answers are ‘correct’ – it merely reveals my investing style, which can be summed up as ‘Safety First’. By the way, there was a typographical error in 1 (d), which reader VJ had pointed out.

Why 1 (d)? Karan summed it up nicely in his answer, and this was really the only ‘correct’ answer in Q1. The other options are too risky. The answer option I didn’t provide was: “Nothing – because I do not buy or sell on tips”. Every one would have chosen that option!

Small investors should stay away from small-cap stocks in general – because of low liquidity that makes buying and selling difficult, and due to lack of financial staying power through tough times. But if you do buy a small-cap, maintain a stop-loss of no more than 8%. A 20% price drop may be a sign of worse to follow – so get out.

Why 2 (b)? Most of you chose option (a), which is not ‘wrong’. As a general rule, don’t average down because you don’t know how far the stock may fall. This is a rule for small and mid-cap stocks. For large-caps – if you have done your homework before buying, a 10% drop in price is a good opportunity to add. (Follow the thumb-rule of never buying near a 52 week high.)

Why 3 (d)? No one chose this option, except Venkat. Most chose (c), which isn’t ‘wrong’. The situation described is called a ‘panic bottom’ – which usually happens during the first or second stage of a bear market. Such bottoms are invariably broken, and the stock tends to fall much lower. So you may be better off by closing the trade, and buying lower again after the stock bottoms out.

In such stocks, it is good to keep a stop-loss between 8-15% – to avoid a 50% drop.

Why 4 (d)? Almost every one chose this option. The point I was trying to make is that investors get hung-up with round numbers. If you buy at 10 you want to sell at 15 or 20. If you buy at 50, you want to sell at 75 or 100. Markets rarely work to suit your convenience. In a low-priced stock – which investors should avoid in the first place - it is better to start taking profits home whenever they are available. Most investors get killed when they go out to make a killing!

Why 5 (e)? Only Saurabh and Joe chose this option. There are two points here. In a step-wise up move, prices tend to find support near previous tops. Those are good places to add. Since we don’t know if 55 was a previous top or not, we would not know if the correction will stop at 55 or fall further.

Also, it is a good idea to take profits at a 52 week high – more so because the original investment has doubled. Remember that you make money only when you sell. So you need to have a selling plan when you buy a stock.

Venkat gets the hat-tip for the ‘best’ answer. His responses suggest that he isn’t a ‘new investor’ any more!

Thanks once again to all who participated in the quiz. For those who didn’t participate – hope you will be able to pick up a few pointers from this discussion to improve your buying and selling.

10 DOs and DON’Ts for making money in the stock market

Making big money – really big money – that allows you the freedom to do what you want, when you want and wherever you want must be the dream of every human being in the planet (except those who become monks or nuns). Only a few manage to make the dream a reality.

Those who follow the straight and narrow path end up toiling all their lives – slaving at a job, or trying to run a profession or business. Those who prefer a more crooked road usually have a short career and end up as state guests with free room and board – unless they manage to become politicians powerful enough to stay away from the long arm of the law.

Making really big money is not a realistic goal for most law-abiding citizens. But making a lot of money – enough that you can have a comfortable retired life that doesn’t require you to cut corners and lets you enjoy some of the material pleasures that life has on offer – is a more achievable goal. The stock market is a place that can help you to achieve the goal by supplementing your regular earnings.

Here are 10 DOs and DON’Ts for making money in the stock market:

DO…

1. Make a financial plan. You don’t have to be a CA to do this. All you need is a little common sense and some knowledge of arithmetic. Think of all the major expenditures – children’s education, daughter’s marriage, buying a flat – at different times in the future and assess how much money will be required for each. That will give you an idea of how much you need to save.
2. Make an Asset Allocation plan. This is the key. You need to know how much of your savings you should invest in risk-free instruments like Post Office MIS or bank fixed deposits, and how much you can afford to invest in riskier instruments like mutual funds and shares. By maintaining a plan, you will know when to buy and when to sell.
3. Learn about the stock market before entering it. Can you get into an IIT or IIM from the Kindergarten? Can you face the fast bowling of a Brett Lee or a Dale Steyn if all you have played is tennis ball cricket? In the stock market, you will be playing against the likes of Rakesh Jhunjhunwala and Ramesh Damani. If you don’t know what you are doing, they will take all your money. Read books by Gurus like Graham and Lynch.
4. Learn how to select stocks and build a portfolio. Haphazardly buying and selling stocks (or funds) on some one’s advice or your ‘gut feel’ is a sure way to make losses. Learn the process of selecting stocks for a portfolio, and holding for the long-term. There are several articles on this blog that can get you started.
5. Learn to be patient and disciplined. The stock market is not a place for showing off how smart or enterprising you are. Those qualities are great for a business venture. In the stock market, you have to be observant and vigilant. Choose the times you want to buy (near bear market bottoms) and the times you want to sell (near bull market tops) carefully. The rest of the time, just wait and watch. Rome wasn’t built in a day. Neither will your wealth.

DON’T…

1. Think that making money in the stock market is easy. The stock market isn’t a zero-sum game. While there is a buyer for every seller, only a few make money. The majority lose. They are the ones who thought making money was easy.
2. Feel like a genius if you have made some money. It was most likely a combination of luck and a bull market. Going through bull, bear and sideways markets with your wealth intact requires determination and perseverance. If you are feeling excited and having fun, a loss is just around the corner.
3. Forget Buffet’s Rule No. 1. Regardless of whether you have a shorter or longer investment time frame, always set stop-losses. That will help you to limit your losses. If a stock is running up fast, set a trailing stop-loss. (If you don’t know anything about stop-losses, you need to read my eBook. It is FREE.)
4. Be too greedy. Have profit targets for each stock (or fund) in your portfolio. Once the target is hit, sell 50% and hold the rest with a trailing stop-loss. Sell all when the trailing stop-loss gets hit.
5. Ever trade. According to Peter Lynch, the odds of success are greater at the race track or casino. Most trade to get rich quick. But there are no short-cuts in life. Trading is the best way to get poor quick; or, to become a reluctant long-term investor (when the trade goes completely wrong!).

There are no sure-shots in the stock market. But if you follow this simple set of DOs and DON’Ts, you will make a lot of money. Not tomorrow, or the day after. But after 20 years. Might as well get started now.