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The golden rules of investing
rediff Business Desk | February 08, 2006
The Sensex is on fire, notwithstanding Wednesday's dip. It's a bull run like no other witnessed by Indian investors. And investment gurus -- like Marc Faber -- say this bull run could last for a decade or more!
While it is time to rejoice at the booming Indian economy and the historical journey of the Sensex, the foremost question in the minds of all small investors -- like us -- is whether it is the right time to buy or sell stocks now.
So what does the layman do in times of a roaring bull market? Are there any rules for you and me to follow while dealing in the stock market? What should you avoid doing? And, more importantly, what should you do?
Of course, there are some golden rules that you must follow. And these have been culled from a variety of sources: writings by investment gurus, articles in newspapers like Business Standard and Web sites like Equitymaster.com, opinions of brokers and analysts and a whole lot of others who have learnt the art of investing the hard way.
So here are some golden rules of investing to follow, especially in a bull market:
1. Don't be greedy: Do keep in mind that it is not always that you would be able to buy a stock when it is as its lowest price and sell it when it is at its highest. Do not be greedy. Invest smartly, with some professional help and some study on your own.
2. Avoid 'hot tips': Stay away from 'experts'. There are a large number of so-called experts floating all around. Stay away from them. Your broker, neighbour, cousin or business journalist friend may suggest surefire picks. Success may not come as fast, as we are in unchartered territory. Use your own judgement.
3. Avoid trading/timing the market: Like in the previous point, don't try to time the market by betting on when the stock price will be highest or lowest. In most cases, such 'timing' leads to huge monetary losses and mental tension.
4. Avoid actions based on sentiments: Don't be emotionally attached to stocks: Some people -- for sentimental reasons -- tend to stick with certain stocks even though they might not bring them good value. Sentiment can be for a variety of reasons: your late father had bought the scrip and you wish to keep it; you had yourself betted on a company's stock thinking it will do good but are now too egotistic to accept your mistake can retreat, etc.
5. Don't panic if the market drops: Be patient and hold on to the scrip until some semblance of sanity prevails in the market. Don't rush to sell the stock. Hold onto your winners and sell your losers. Consult a professional and then act accordingly. Don't let a drop in the stock market alter your long-term investment plans.
6. Stay invested, possibly continue to invest more: It is natural to book profits with the markets at higher levels. This should be done, but we suggest people should also stay invested in the equity markets. Indian stocks do not appear overstretched at present, considering that average price/earnings ratios -- a common measure of value -- were around 15-16 times.
7. Buy stocks if there is a 5-8 per cent drop in the market: In this bull market, a 5-8 per cent drop in prices offers you a good opportunity to buy scrips.
8. Avoid checking the price of stocks or mutual funds after you've sold them: The grass on the other side will always seem greener and can rarely bring you happiness.
9. Try to avoid penny stocks: While doing your research, attempt to understand which the company is and what it does. Value picking may score above growth picking at this stage. Do not be tempted to buy penny or mid-sized stocks at this stage, envisaging a huge windfall.
10. Diversify: At these record levels, there will be certain amount of risks. We suggest you diversify a bit, looking at stocks, mutual funds, commodities and gold (for a longer-term). If equities are your favourite, we expect you would be able to pick up some of these stocks again.
11. Don't commit large amounts of money: Even if you have a strong risk-bearing capacity, we suggest you do not commit large sums of money at this stage. A sharper correction would just leave you bleeding more.
12. Don't trade for short-term: In line with the stay-invested mantra, do not be completely target oriented. 8,000 or 9,000 are not sacrosanct levels. It is more important to be stock-specific, keeping an internal value for the stock.
13. Don't expect to be a millionaire overnight. Patience pays, so be realistic. 14. Stick to the desired asset allocation: What's asset allocation? Well, the combination of the types of investments you have made within your portfolio is your portfolio's asset allocation. A diversified portfolio consists of equities, mutual funds, real estate, bonds, etc.
Asset allocation is the key to successful investing, say experts. Even though equities may outperform debt substantially, it will not be wise to put all your investments in equities.
Investors should allocate assets among various asset classes - primarily equities and debt - based on their risk appetite. Being overweight by about 10-20 per cent in equities may be justifiable, say fund managers.
In other words, if you are advised to allocate 20 per cent of your investments into equities based on your risk profile, you could consider a maximum exposure of 40 per cent currently given that equities are poised to surge ahead.
14. Distinguish between stocks for keeps and trading: When you buy a stock, be clear about your objective behind the purchase - whether you have bought the stock as an investment or a trading bet. Trading stocks are not bad as such. But they require you to work harder and act quicker.
Buy with adequate margin of safety: That's where attractive purchase prices can help. As a matter of fact, selling stocks is no different from buying them. Keep a sufficient margin of safety when buying a stock and don't rely on making a good sale ever.
15. Sell when value is realised: Some stocks may rise sooner than you may have anticipated. In a frenzied bull run, investors may see their target prices being met in a matter of days. Here time should not be of any consequence.
If you feel that your investments are adequately valued, you should exit regardless of how long you have held them. There are times when stocks begin to quote at extraordinarily high levels within a short period after you have invested in them.
Although investors are often advised to invest for the long term in equities, if you get extraordinarily high returns within a short span, it is wiser to get out, say experts.
16. Keep a watch on relative valuations: The real cost of a stock is not the price you pay for it, but the opportunity cost of not putting your money in another stock with a greater potential to rise. Let's say you hold a smaller pharma company and find that a larger one is also available at the same multiple. It may make good sense to switch. A larger company, with more liquidity and visibility, will be preferable.
While buying a stock most investors look to buy the cheapest of the lot. Indeed, that is the right approach. However, it may not be a good idea to buy a stock just because it is cheap in relative valuation terms.
When stocks become overvalued there is little logic in holding on to them just because they appear cheaper than others.
17. If you realise a mistake, exit: Even while we are talking about selling stocks in a bull market, experts emphasise that if investors make mistakes, they should exit immediately even at a loss.
If you realise your analysis was flawed or that you got carried away for any reason, it's good to get rid of a stock as soon as possible. Waiting for a better price at such instances may prove to be quite dangerous.
18. Start investing early.
19. Try to invest in things you know .
20. Try to adopt a long-term perspective with regard to investing.
21. Know your risk: It is critical to understand where you stand and where you want to be. What level and amount of investment are you comfortable with, regardless of what market experts tell you? Therefore, take some time to evaluate your risk-bearing capacity. This is a golden rule that should be applied at almost all times.
22. Play safe, invest in a mutual fund: For those who are still not sure about their research, we suggest you invest through a mutual fund. The advantages would be the risks would be minimized and you would stay invested for a longer-term in equities.
23. Encash when stock prices dip: We reiterate it is important to bring some money home, when you have made profits in earlier times. We expect a correction to take place, which could be in the range of 300-500 points. Considering that you would stay invested in equities, we advise that you encash at each dip of the Sensex. The short-term trend will be stock specific.
24. Don't blindly follow media reports on corporate developments, as they could be misleading.
25. Don't blindly imitate investment decisions of others who may have profited from their investment decisions.
26. Don't fall prey to promises of guaranteed returns.
With inputs from the Bombay Stock Exchange, the Securities and Exchange Board of India, Business Standard and Equitymaster.com