A common investing mistake - and its remedy

A common investing mistake made by many small investors is to wait far too long, and let buying or selling opportunities slip away. When the stock market is rising, and portfolio values go up in leaps and bounds, the tendency is to hang on to the stocks or funds in the portfolio to try and squeeze out the maximum amount of profit. The wait to sell keeps getting longer and longer and one fine day, the market cracks for no apparent reason. The investor rues the fact that a selling opportunity near the top was missed.

When the stock market is falling, the same psychology plays out in reverse. Investors try to buy a selected stock or fund at the lowest possible price, and keep waiting and waiting to buy at even lower prices. Out of the blue, the market turns and starts to rise - as if throwing caution and common sense to the winds. A buying opportunity near the bottom is missed.

Seasoned professional investors find it tough to correctly time stock market tops and bottoms. Imagine how much more difficult it is for amateur investors to catch market tops and bottoms. It is not worth trying unless one has become adept at identifying technical signals - and that takes years of practice.

There is a simple way to remedy the mistake of waiting too long and losing opportunities. Inculcate the habit of being fully invested. Regardless of whether the stock market is moving up or down. But it requires a bit of planning and a large dose of discipline. First of all, investors require a financial plan based on their income, savings and existing and future financial commitments. Help can be sought from a professional financial planner (for a fee) or a CA friend (for free). But it isn't rocket science. Knowledge of Class 5 arithmetic is good enough to do it yourself.

Then one needs an asset allocation plan, based on risk tolerance. This post explains the concept of an asset allocation plan. Once the plan is in place, investors should have the discipline to stick to the plan at least for two or three years. Change the plan only if things don't work out. Investing without a plan is like travelling without a destination.

If the asset allocation plan indicates it is a good time to buy (because the equity portion of the allocation has fallen below a pre-set threshold level), start buying systematically. By using cost averaging or value averaging concepts. Read about these concepts in this post. Identify a couple of good stocks or funds. Then decide how much of each you want to buy value-wise. Spread out the buying over a few months, till your asset allocation plan is rebalanced.

If the asset allocation plan indicates it is time to sell (because the equity portion of the allocation has exceeded a threshold level), don't wait any longer. Start booking profits partially. To find out more about partial profit booking, read this post. Remember to keep the flowers and cut the weeds in the portfolio first.

Should you invest in large-cap or mid-cap stocks?

The stock market has been in a down trend for more than a year – losing 25% from its Nov ‘10 peak. Experts suggest that such falls provide excellent opportunities to accumulate strong large-cap stocks. Large-cap stocks are less risky and offer steady rather than spectacular returns.

Most small investors have a penchant for seeking out small and mid-cap stocks in the hope of making multi-bagger returns. But high returns are usually accompanied by high risks. What should small investors do? How to contain risk without missing out on returns?

In this month’s guest post, Nishit looks at the pros and cons, and comes up with an alternative approach.

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The argument will always continue whether to invest in large-cap or mid-cap stocks. One of my friends was asking me this morning whether it would be a good idea to invest in mid-cap IT stocks. It was the trigger for this post.

Mid-caps have several advantages. They are the real multi-baggers. Microsoft and Infosys were mid-caps once upon a time. Mid-caps can be a 10-bagger or even a 100-bagger. Mid-cap stocks carry a greater amount of risk as compared to large-cap stocks. In a bear market, a large-cap may lose 50% of its value whereas a mid-cap can lose as much as 90-95% of its value.

So, how does one address this conundrum? Every portfolio needs to be garnished by a sprinkling of mid-cap stocks, just like our food needs a sprinkling of salt to add to the taste. Just as too salty food is not good for health or taste, too many mid-caps is not good for the health of your portfolio, which leans towards risk.

How does one identify good mid-cap stocks? There are several criteria one must keep in mind.

1. They should have sound business models.
2. They should be generating real profits.
3. They should have good management. This is a very tricky question. How does one see a management to be good? A small investor cannot go and meet the management of a company he likes. One must look through the annual reports and notifications of the stock exchanges. The promoters should not have a shady reputation, or indulge in activities that harm shareholders – such as pledging of shares or dazzling announcements aimed at TV and newspapers.
4. The companies should be generating positive cash flows and providing steady dividends. Steady dividends can be ignored if the business is growing and the promoters are not investing the money in unrelated activities.

Now that we have looked at what criteria to use in selecting a good mid-cap company, the next question is when to invest. In bear markets, mid-caps are battered beyond recognition. Hence, one can follow this strategy. Keep accumulating large-cap stocks on every dip.

For mid-caps, buy only if the Nifty sustains above its 200 day Moving Average for a week or more. 200 day Moving Average is considered the dividing line between bear and bull markets.

Also, depending on one’s risk profile, the allocation has to be done between large-cap and mid-cap ideas. A conservative portfolio can have a 80:20 ratio between large and mid-caps. A more aggressive portfolio can have 60:40 ratio between large and mid-caps.

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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. 

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.

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?

How to reallocate your assets

Why is the stock market so excited about an unexciting budget?

These are the irreverent views of a non-economist. Take them with a pinch of salt.

It isn’t bad, so it must be good

There was a lot of uncertainty surrounding the budget this year. Rising inflation was not contained even after several interest rate hikes by the RBI. Higher interest rates were beginning to slow down Indian Inc’s growth momentum. Some tough tax measures were expected from the Finance Minister (FM). None came. The markets heaved a collective sigh of relief.

Shorts got trapped

The four months long correction in the stock markets had turned sentiments negative. All attempts at pullback rallies were getting sold into. The FIIs were selling heavily and redeploying in their home markets. Several experienced players were shorting the market. The unexpected surge in the indices on Budget Day was mainly due to short covering.

Auto sector gets an indirect boost 

A 2% excise duty cut was offered to auto makers a couple of years back as part of the economic stimulus. A roll back was discounted by the market. The FM left the excise duty unchanged. Feb ‘11 auto sales numbers have shown decent growth. Auto stocks soared on this twin good news.

Smart move from ITC

An increase in excise duty for cigarettes and other tobacco-related products was widely expected. In anticipation, ITC had increased the prices of some of its most popular brands prior to the budget. No such increase was announced by the FM. Don’t expect your pack of smokes to get cheaper. ITC’s bottom line will be a direct beneficiary.

Not so great for Mukesh Ambani

By transferring his shareholding in Reliance to a clutch of Limited Liability Partnership (LLP) companies, Mukesh Ambani ‘legally’ avoided paying income and other taxes (such as dividend distribution tax). LLPs have been brought under the purview of 18.5% MAT. Bad luck for big brother – he has to now pay taxes like a mere mortal! If only he had known earlier, he may not have built the ostentatious eyesore he calls home.

Reduced surcharge on corporate taxes

This would reduce cash outflows, and is a definite positive. Hopefully, the extra cash will get channeled into expansion activities and help to increase GDP growth. Investors may get rewarded with higher dividends.

Tax benefits for senior citizens

By reducing the qualifying age for a senior citizen from 65 to 60, several lakh tax payers will be able to avail higher tax exemptions. Some of the extra tax savings are likely to find their way into MFs and equity.

Does all this justify a 600 point rise in the Sensex today? Is the correction over? Should investors start buying again? Answers to these questions will become clearer over the next few days – now that the uncertainty about budget proposals are behind us.

Don’t let relief cloud reality. There has been little change in the global or local situations. Uprisings continue in the Middle East. Higher oil prices will further stoke the fire of inflation. Get set for another interest rate hike. FIIs were net sellers on Budget Day. The Sensex and Nifty are near strong resistance zones.

Stick to your asset allocation, and don’t get swayed by short-term index moves.

Become a better investor by learning how to swim

There is an old English idiom: Birds of a feather flock together. But the stock market is populated by strange birds that care two hoots about English. They prefer to follow the laws of physics – particularly the one that states: likes repel and unlikes attract.

So we have a variety of investors who are polar opposites – bulls and bears, active investors and passive investors, long-term investors and short-term traders, growth investors and value investors, those who trade on margin money and those who invest their savings, investors who try to make money and investors who try to build wealth. And all these opposites get attracted to the same market place, and think that their ideas are the best!

But the two types of investors that really matter – and needless to say that they are also polar opposites – are those who know what they are doing and those who don’t. The old pros and the babes in the woods. The ‘smart money’ and retail. It is not a level playing field. The scales are heavily weighted in favour of those who know what they are doing.

It is a chicken and egg situation for the new investor. How can you learn to swim if you are afraid to get into the water? But if you jump in before learning to swim, you might drown. Is there a way out? Fortunately, there is.

I learned to swim by myself by thrashing around near the bank of a pond. A lot of water got inside my lungs, nose and ears – and it wasn’t a pleasant experience at all. But I persisted and learned to do the ‘dog paddle’.

Eventually, I had to seek help from an expert swimmer – to learn proper swimming strokes and breathing techniques. I am not a pro, but consider myself an expert swimmer. Still, I’m very wary of diving into a fast-flowing river or a rough sea – because I don’t have sufficient experience of swimming under those adverse conditions.

Will you jump into the sea without any fear if you find yourself facing a barrage of 10 feet high waves? If yes, will you also be able to fend off a shark attack? The stock market is like a rough sea. The sharks are the old pros out to feed on young fish like you. Why become some one’s dinner?

Start learning to swim at the shallow end of the pool by investing in a bank recurring deposit and an index fund. After you have built up a corpus, take the help of an expert swimmer to understand financial planning and asset allocation, fundamental analysis and technical analysis. Only then should you venture out to sea.

Planning for a hassle-free Retirement (a guest post)

Do you remember what you did with your first pay/payment cheque? (Haven’t received your first cheque yet? What are you doing on this page!) Did you blow it up having a good time with friends and family? Why not? You don’t remain young forever. There is a long and bright future ahead of you – and plenty of time to save and invest. Right?

Nishit doesn’t think so. He started planning for his retirement as soon as he received his first pay cheque. He wanted to use the leverage of compounding over his entire working life. In this month’s guest post, he explains why.

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Everyone invests money with the aim of having a comfortable nest egg at retirement. Most of us have not worked out how much money we need at retirement, and at what rate of return we will be comfortable. Most of us chase multibagger returns in the equity markets, burning our fingers in the process.

The magic of compounding is such that 1 lakh invested in the markets today turns into 19 lakhs after 20 years at a rate of 16% return every year. To make 16% every year your asset portfolio need not take undue risks. A Government securities fund over the past 10 years has given a compounded return of 9% on an annualized basis, and a good mutual fund like the HDFC Top 200 has given annualized return of 34% over the past 10 years.

Inflation is a monster which is like a silent killer. Now assuming an inflation rate of 8%, after 20 years, expenses of 1 lakh become 4.66 lakhs. Your assets of 1 lakh have transformed into 19 lakhs whereas the expenses have just gone up to 4.66 lakhs. You have a nice cushion of 14 lakhs.

Gold as an asset class has also yielded an annualized compounded return of 17% over the past 10 years. The trio of equity, gilt funds and gold should form the cornerstone of any investment portfolio. What I am trying to point out here is that investments need not be complex; any common person can invest making use of investment vehicles like Mutual Funds.

The above returns are through investments using the SIP (Systematic Investment Plan) method. One can invest a fixed amount every month, say Rs 5000 each, in a gold ETF, equity fund and a Debt fund. The idea of doing this is that you do not try and catch the bottom or top of any market. One need not invest in too many funds at one go.

India’s economy is growing and will continue to do so for the next 10 years at least. Anyone who is planning to retire with a comfortable income must start doing a SIP at the earliest. By doing this, one can ensure that one is financially independent after retirement. Add to this a Medical Insurance policy that will cover major health care expenses post retirement. The earlier one buys a Medical Insurance policy the fewer are the tests one has to undergo and easier it is to get one. Everyone should have a personal medical health insurance policy, as company policies expire when one leaves the company.

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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 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.