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.

Stock Chart Pattern - IRB Infrastructure (An Update)

The previous update on the stock chart pattern of IRB Infrastructure was posted almost two years back. The stock appeared to have made a double-top at 280, which was much higher than the minimum target of 229 mentioned in a prior post, and readers were advised to book partial profits. Was it good advice?

A look at the two years bar chart pattern of IRB Infrastructure will reveal that the advice was timely, even though the stock did rise another 10% to touch an intra-day high of 313 on Aug 24 ‘10:

The stock did not form any discernible reversal pattern, except that it formed a ‘reversal day’ pattern (higher high, lower close) on the day it hit its peak of 313. Reversal day patterns typically mark the end of an intermediate rally (or correction), but some times they can form at bull market tops and bear market bottoms – giving a very small window of opportunity to buy/sell.

This is why partial profit booking should be done when targets are met on the upside. Likewise, slow accumulation should be started when downward targets are met. It is next to impossible to catch the exact tops and bottoms.

The stock price started to correct rapidly and dropped below the 200 day EMA in Oct ‘10. It attempted a bounce back above the long-term moving average, but faced resistance form the falling 50 day EMA. A sharp fall below the 200 level in Nov ‘10 coincided with the ‘death cross’ of the 50 day EMA below the 200 day EMA – confirming a bear market.

All up moves faced resistance from the falling 50 day EMA till the stock dropped to an intra-day low of 150 in Feb ‘11. This time, the up move managed to climb above all three EMAs, but failed to clear the 229 level. Interestingly, 229 happened to be the top touched in Aug ‘09 – and the minimum upside target mentioned in an earlier post in Jun ‘09.

The dark blue down trend line drawn through the tops at 313 and 229 ruled IRB Infrastructure’s chart pattern till it touched an intra-day low of 121 on Jan 3 ‘12 - a 61.3%drop from the peak of 313 – underperforming the Sensex by a huge margin. Such are the risks associated with mid-cap (and small-cap) stocks. They tend to outperform in bull markets and underperform in bear markets.

The ongoing rally from the Jan ‘12 low has risen more than 20%, crossed above all three EMAs and the down trend line. The first two of the four criteria of a bull market (mentioned in a recent post) have been met. The rising 20 day EMA has crossed above the rising 50 day EMA and is about to cross above the 200 day EMA.

The technical indicators are correcting from overbought conditions. The MACD is positive, but has changed direction and dropped on to its signal line. The ROC crossed below its 10 day MA and fell all the way down to the ‘0’ line before bouncing up a bit. Both the RSI and the slow stochastic have dropped from their overbought zones. Expect some consolidation and a possible pullback to the down trend line.

Bottomline? The stock chart pattern of IRB Infrastructure is poised to change trend and enter a bull market. Many mid and small-cap stocks are showing similar chart patterns – on the verge of re-entering bull markets, thanks to relentless FII buying. Use dips to enter, but with a strict stop-loss. Q3 result was so-so – flat net profits on a slight increase in turnover.

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?

How to reallocate your assets

NSE Nifty 50 – a quick mid-week update

Some readers have written to me over the past couple of days, asking whether the worst is over for the Nifty and is it a time to buy. It is better to have a long-term view, and not be too bothered every time the index rises or drops by a couple of percentage points.

The ‘buy low – sell high’ theory is not just that. It works practically as well. How does one know when the index is low enough to buy and high enough to sell? Just look at historical P/E values of the Nifty, and check the range within which it trades most often. You will get the answer.

However, since the question has been raised by a few, there may be others who are thinking along the same lines. So, here is a quick update of the 1 year Nifty bar chart pattern:

 

Note the following points, and their implications:

1. Volumes have been strong during the past 5 days rally – bullish

2. The Nifty has crossed above the 200 day EMA after 2 months – bullish

3. The index touched a marginally higher top for this month – bullish

4. The ROC and the RSI reached lower tops while the Nifty reached a slightly higher top – bearish (negative divergences)

5. Last, but definitely not the least: the blue downtrend line has not been crossed yet – bearish

As long as the downtrend line is not breached, the 8 months long corrective phase remains in place. This up move gives an excellent opportunity to book partial profits.