Money is a very strange thing—human beings make rational decisions while dealing with most aspects of life but make serious errors of judgment when it comes to dealing with money—be it saving, investing, borrowing or spending—and probably none are so glaring then when it comes to investment in equities. Completely rational investors take totally irrational decisions when part of crowd—their own individual rational minds come down many levels to the irrational level of the crowd.
Many a times, individual rational intelligent persons commit simple mistakes while making investment decisions in common stocks. And market has its own method of finding and exploiting human weaknesses. Mehrab Irani explains some of the most common mistakes which investors commit while investing in common stocks.
Mistake 1: Trying to catch the top & bottom
This is one of the most common mistakes while investing in equities which most investors commit i.e. trying to catch the top and the bottom little realising that only fools can catch the top or the bottom. No government, central bank, company management, fund manager, analyst or anybody knows what will be the exact top or bottom of any stock, then how does a common investor believe that he / she will be able to catch the top or bottom.
Instead of that, determine the value and target price of any stock in which you intend to invest by whatever method you may follow—fundamental, technical or any other method—and then buy it within 5% to 10% range of your that “buy price”. You may pace out the purchase over a period of time keeping in mind the current performance of that company and / or the overall market conditions.
Once you determine the “correct price” for a stock to buy by whatever method you may follow and when that price approaches, don’t wait to “buy at the bottom” because you will probably never be able to do that.
If you wait too long to buy, until every uncertainty is removed and every doubt is lifted at the bottom of a market cycle, you may keep waiting and waiting. The same rule will apply while selling also.
Mistake 2: It will come back
This is another common mistake which most investors commit while investing in equities—whether on the buying or selling side. If they see a certain price for a certain stock and they miss buying / selling at that price, they keep waiting in anticipation that the same price will come back, irrespective of market or individual stock considerations.
For example, somebody might have decided on the basis of his / her analysis that Unitech is to be sold. Then he / she saw the price of Rs. 530 in January 2008 but “missed” selling at that price and after that the stock started falling because of general market weakness and fundamental deterioration in the company. But, the investor who is influenced by this common mistake and waiting for the “price to come back” might still be waiting with the current price around Rs. 26 and I don’t know whether the price of Rs. 530 will ever come back!
The lesson to be learned is that if the price of the stock has gone up / down for a change in the prospects of that company or sector, then there is no point being in illusion that the “price will come back”.
Mistake 3: Already fallen so much—Can’t fall further
This is one another serious mistake which many investors commit while investing in equities. A stock might have fallen “considerably” and hence they believe that now it cannot fall further.
Nothing can be further from truth as this is one of the grave mistakes which results in multiplication of investor losses. Continuing with the Unitech example, the stock fell from Rs. 530 in January 2008 to Rs. 240 by March 2008, a massive fall of 45% in just two months. Now, any investor who might have believed that it can’t fall further because it has already fallen 45% in two months. Hence held on to it / purchased it was in for a rude shock as it fell to Rs. 20 by December 2008, a massive 96% from the top and also a substantial fall of 92% from the March 2008 level of Rs. 240.
Unless the stock becomes attractive on a standalone basis on whatever analysis you may believe in, there is simply no logic in believing that “because it has already fallen so much and therefore it can’t fall further”.
Mistake 4: Already risen so much—Can’t rise further
This is the corollary of mistake number 3—Many times investors believe that since the stock has risen so much, hence it cannot rise further. For example, Titan rose from around Rs. 5 in July 2004 to Rs. 42 by March 2006, stupendous jump of more than eight times in less than two years.
Anybody, thinking that the stock has risen so much and therefore can’t rise further and sold it was for a rude surprise as the stock rose to Rs. 237 by September 2011, not only swelling by 47 times from its July 2004 price of Rs. 5 but even multiplying by around 5.5 times from its March 2006 level of Rs. 42.
Hence, unless the stock becomes expensive on valuation basis / future growth expectation basis or any other “price determination” parameter which you might be successfully applying, simply because the stock has risen so much does not warrant a sufficient reason to sell.
Mistake 5: Protect your profits or cut your losses
Unless you are a short-term trader or investing on costly leveraged funds, there is no point in trying to “protect the profits” or “cut losses”. Unless the stock becomes costly on valuation basis or its fundamentals deteriorate on a long term basis or because of some other “price determination” parameter which you might be using, just because a stock on which you are making money corrects, it does not necessitate you to panic and sell out of it to “protect your profits”.
Let’s continue with the above example of Titan. After multiplying by about eight times from Rs. 5 in July 2004 to Rs. 42 in March 2006, the stock corrected to Rs. 21 by May 2006, almost halved from its peak of March 2006 in just two months. Any investor who might have panicked and sold the stock then would be in for a nasty surprise as the stock then went on to Rs. 85 by December 2007 i.e. four times jump from the May 2006 low and beyond that as we now know it has touched Rs. 237 by September 2011.
The same principle would apply for cutting losses as you might be cutting your losses just before the stock is on the verge of embarking on its dream run. Let’s continue with the Titan example above. Now, suppose you purchased the stock at Rs. 42 in March 2006 and it halved to Rs. 21 in the subsequent two months and you are nursing a massive 50% loss.
On the fallacy of “cutting your losses” if you sell the stock at Rs. 21 then you have sold it just before it was getting ready for its next dream run which would lead to many times price multiplication over the next few years. Hence, after doing your analysis if you feel that the price is right for selling than only sell the stock and not on the misleading notion of protecting your profits because by doing that you might be cutting any probability of serious wealth creation in the future. The same would apply to “cut your losses” fallacy also.
Mistake 6: Price averaging
This is another grave mistake which investors do which takes them deeper down the loss lane. There is a wrong notion then averaging brings down the purchase cost and hence would be able to sell it at some marginal profit or at least closer to cost price. Let us move back to the example of Unitech, suppose you invested in 1 share at Rs. 530 in January 2008, then “averaged” by buying one more share at Rs. 300 in February 2008 and further averaged by purchasing another one share at Rs. 240 in March 2008 so that now your reduced “average cost” is Rs. 357. But, what purpose has that served, today the stock is quoting around Rs. 26, down by a phenomenal 93% from the reduced “averaged cost”.
One caveat, that sometimes an investor might get an opportunity to ext in the averaged stock at close to the “average cost” but those opportunities are rare and only for a short period of time and therefore very difficult to capitalize at that point of time. And finally, if you would not otherwise want to buy a particular stock at a particular price then what is the logic for averaging it if you already own your stock.
Never throw good money after bad money. If you have made a mistake in selecting a wrong stock, humbly accept your mistake, sell it and book your loss and move ahead, use the proceeds from sale to buy better investments with potential of price appreciation in future.
Mistake 7: Stocks gone up so I am right or gone down so I am wrong—The Market Trap
Ego and lack of self confidence are both negative qualities of a human being and an investor. If you buy a stock and it goes up for no real reason but for market abnormalities then be smart enough to sell it and get out of it instead of pampering your ego that you are an astute investor or a great stock picker. Don’t forget that the market is a great deflator of all egos.
The same can be true when you might have invested in a stock at a decent price after all your analysis and the stock falls for no deterioration in the company’s performance but for some uncontrollable market reasons—during that point of time there is no need to panic and lose self confidence and start believing that you are wrong.
Market can be wrong and is in fact wrong most of the times, so try to take advantage of it abnormalities by using your knowledge, experience and judgment instead of getting swayed away by it and losing your self confidence.
Mistake 8: Efficient Market Theory
Don’t blindly believe in the efficient market theory. Market is inefficient for almost 95% of the time—it’s like a pendulum moving from over valuation to under valuation and then vice versa. Only like a pendulum’s movement from one side (over valuation) to the other side (under valuation) it is just by chance that it passes through the middle (fair valuation).
If the market was indeed always efficient it would be impossible for so many investment gurus and fund managers to “claim that they can beat the market”. Having said that, over the long term the pendulum does move in the direction of what is right—if the country, economy, sector and the individual stock does perform well than over the longer term the pendulum does put its weight behind it, otherwise not.
Mistake 9: Blindly follow the Guru
There is a saying that either you completely trust your judgment or the judgment of another person. The other person in the market is the investment guru or fund manager, etc. You may trust any investment guru of your choice and some investor gurus will beat the market at certain points of time but all the investor gurus cannot beat the whole market on a continuous basis because they only make up the market.
Everybody can’t beat everybody—for there to be a winner, there has to be a loser also. The buyer and seller are always on the opposite side of the trade and they both mysteriously believe that they are right—but one of them is wrong! So don’t trust any of the so called investment gurus at first instance.
Mistake 10: Penny stocks
This is another common mistake which most investors commit—buying penny stocks thinking that the price is already “so low”, most probably in single digit. The amount of loss which can happen in common stock investing is reported in percentage terms and measured in rupee terms, whether it be a penny stock of Re. 1 or a high priced stock of Rs. 1,000. Therefore, if a Re. 1 stock falls to 10 paise or a Rs. 1,000 stock falls to Rs.100, the loss is 90% in both cases.
If you invest say Rs. 1,000 in either of the above mentioned two stocks and both of them suppose become zero, then you lose your full investment of Rs. 1,000, irrespective of the initial price of the stock. Remember the old saying “penny wise, pound foolish”, the stock price is just a quote in the market and on its own does not have any significance whatsoever, it has to be measured in conjunction with the company’s performance, earnings, book value, dividends, etc—a high priced stock may actually be cheap on valuation basis while a low priced penny stock may actually be very costly if the underlying business does not support even that much of a price.
Mistake 11: Fail to past the test of patience and character
Market is a place which will test your patience and character. Many times you might have bought a stock for all the right reasons at the right price but the stock refuses to go up for a long period of time—just hang on to it because the day you get frustrated and sell it off, there are chances the stock will then start rising. Hence, patience and character are key virtues which will be repeatedly tested by the market.
To conclude, there are many simple and avoidable mistakes which investors commit while investing in common stocks and I have tried to explain some of the most common ones of them.
Simple logical things work far better in the market place rather than complex algorithms, theorems, valuations principles, DCF, etc. There is no other place to test your virtues than the market—be it common sense, logical thinking, patience, perseverance, mental balance, emotional intelligence, performing under stress etc. All the qualities which make a successful human being will be tested by the market—it has its own method of finding and exploiting human weaknesses. Investing is not about beating the market or anybody else, it’s simply beating your own self, your own negative traits and once you are able to master your own self and become a complete human being, then only you would also become a successful investor. Avoid the common mistakes while investing in common stocks and embark on becoming a successful investor and a complete human being. All the very best.
The author is the general manager—investments with Tata Investment Corporation Ltd. He writes a blog: www.intelligentmoney.blogspot.com. His first book titled 10 Commandments for Financial Freedom would be released shortly. He may be reached at firstname.lastname@example.org.
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