Thursday, December 23, 2010

Rules to Invest in the Stock Market



The Stock Market has been an enigma to many investors over the past 2 years. We have seen the great highs of 21000 and we have dug deep down to the 7000 levels. The stock market movement is not rocket science but the perception of a majority of Indian investors is otherwise.

Markets move in a cycle, after every high there is a low and after every low there is growth and a subsequent high. But, we feel that the market is unidirectional. If the market is going up (in a bull run) we expect it to run indefinitely and if it is going down (in a bear run) we expect it to stay down forever. Let us take an example that happened recently. Two months back the markets were hovering around the 21000 levels and everyone was full of positive news that the markets will touch 23000 by year end or by next year. The bubble burst within days and it crashed an average of 300 to 400 points every day and went back to the 18000 levels. Again people started correlating bombings in Korea and said that the markets would stay down. Again surprises galore and within a few more weeks the market is back in the 20000 levels.

The Market is never going to grow tired of throwing surprises which effectively means that the best and the most knowledgeable market gurus need to pay attention and watch out for it.

Amidst all this commotion, the market has taught us a few very valuable lessons that we need to remember. It would be good if we keep these lessons in mind and be a prudent investor to avoid burning our fingers.

Rule 1: Always Stay Cautious

There is a saying in physics, what goes up has to come down, that is gravity. Stock markets aren’t proficient in physics and they don't really follow the laws of gravity. People feel that if there is a steep growth in the market values, they feel correction will eventually happen and the story other way round is true to a certain extent as well. So the best approach is to stay cautious when people are acting out of impulse.

At the current levels, the Indian economy is definitely healthy and in a much better shape than its world counterparts, however when the market goes up to new heights despite similar fundamental valuations, it definitely means that we need to exercise caution before jumping into the bandwagon.

The Lesson here is: Stay cautious and do get carried away by the market movements irrespective of the direction in which it is moving.


Rule 2: Forget the Herd Mentality

Though almost all of us (stock market investors) are decently educated and are civilized, a majority of us still follow the herd mentality. Have you seen a herd of cattle walking about in barren land? The first cow is walking because the owner is dragging it but the rest are following just because the cow in front of it is moving ahead. This is exactly what majority of us do. “Follow the Herd”

I am not saying that we must always stay unique and do the contra but still, we shouldn't be doing something just because everyone around us is doing it. When the markets crashed, some people panicked and started selling their holdings. This triggered further panic and everyone jumped on the sell flock and the market tumbled. Did the basic fundamentals of the companies change? NO. Did the companies go bankrupt? NO. Did news say that certain companies are making losses? NO. The answer will be a whole bunch of No’s to all possible questions that might trigger us to sell a stock. But still, we all sold our holdings and the market plummeted.

The lesson here is: Don't follow the herd. Do your research and stay invested. Don't sell just because people around you are doing it.

Rule 3: Book Profits Systematically

Though the rule is simple, this is probably the most difficult one to follow. When a company stock is going high all of us are tempted to say this “Just a little bit more and I will sell and make a good profit”. Haven’t we all been in this shoe? Definitely we have. But unfortunately, this approach rarely works. It is always advisable to exit from the market in phases. When we buy a stock, it is good to chart out a future course of action based on market movement. We must plan to sell a % of our holdings in the company when it reaches a certain level. This not only helps us to reduce risk but also provides us with an opportunity if the market moves on further. In the whole greed of a just a little bit more, many of us often lose all our holdings and sometimes even get into red.

The Lesson here is: Decide how much growth a stocks price can make over the next few months and decide a target. If the stock reaches the target, book partial or full profit so that, in case the stock tumbles, you don't end up with a full red portfolio.

Rule 4: Stay Away from Penny Stocks

We are all attracted to Penny Stocks. These stocks cost us around Rs. 10 or 20 each and even a small investor can afford hundreds of thousands of shares. Some of them even blow the roof and grow at over 50 or 60% in a matter of days. However, such rises may be purely based on rumors or speculations and they may lack sound fundamentals or financials. Every time you will see that a penny stock which was a hot pick during a bull run, will be nowhere to see when the markets go bust. In fact, these are the ones that go down first and some may even shut down their businesses.

The Lesson here is: Stay away from penny stocks. It is better to buy the shares of a good company with solid fundamentals at Rs.1000 than buy 100 shares of a tom-dick-n-harry company at Rs.10 each.

Rule 5: Forget Fear and Greed

Fear and Greed are two things that determine the way we act or react. When the markets were at the 21000 levels, everyone was sure that it would keep moving northwards, however when the decline started when least expected, panic selling occurred and the market fell terribly.

Fear and greed always have an upper hand in markets, during bull run markets are driven 70% by greed and 30% by fear whereas the same is reverse in case of bear phase. A contrarian strategy always helps, when people are fearful that the markets will come down be greedy to grab the stocks at a particular price, when people are greedy that the markets will climb further be fearful and start exiting from the markets.

The Lesson here is: Don't be afraid of making losses. Every person who claims he is a stock market guru would have incurred losses at some point of his life. The trick is to avoid greed and make wise decisions that can bring profit to us.


Rule 6: Don't forget Debt

Almost every stock market expert would say – “Keep a portion of your investment in debt instruments like band deposits or bonds” Yes you read me right. Debt is a very important asset class. It gives us the cash cushion that we always need and also gives our portfolio its much needed diversification. All wise investors know that they mustn’t put all their eggs in the same basket.

The Lesson here is: Have a diversified portfolio and don't forget debt instruments. You may end up with lesser profits than your counterparts during a bull run but you will be the happiest man of the lot during a bear phase or a market crash.

To Conclude:
Am not trying to be spoil sport about the market going to new heights and nor am I suggesting that the market will go down again. All I am saying is, it is better safe than sorry. After all, its our hard earned money isn’t it…

Happy Investing!!!

7 comments:

  1. Nice thoughts on Do's and dont's of the capital markets. This post really acts as a ready reckoner for all investors.

    ReplyDelete
  2. HIi anand what are penny stocks?

    ReplyDelete
  3. @Manjula

    A Penny stock is something that is of extremely low cost per share and does not belong to a strong or well-known company

    for ex: shares of xyz private limited that is currently trading at 50 paise per share can be an example of a penny stock

    ReplyDelete
  4. I want to know that how do you invest in the stock market? If you have some strategies about it then please share with me. Thanks.

    ReplyDelete
  5. @ Invest in the stock markets

    Sorry, I do not provide stock trading tips or advise

    ReplyDelete
  6. Hi Anand,
    How to know about the fundamental of a stock.. Is there any ways to find it..

    ReplyDelete
    Replies
    1. Hi Niranjan,
      There is a whole concept called Fundamental Analysis. I will be writing an article about that very soon in this blog.

      Regards
      Anand

      Delete

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