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Investing in stocks? Don't make this mistake

Arnav Pandya | December 08, 2008 08:06 IST

A common mistake that most investors make while investing in the stock markets is getting carried away. And it happens in many situations � entering too late, exiting too early, looking at numbers every day and the worst, calculating losses on a day-to-day basis. 

Most investors tend to forget that though the basic idea is to make money, like everything else, it is not an easy job. Good times will be interspersed with bad times. And sometime, the latter may go on for a long time.

What is more interesting is the way these numbers are calculated. Often it is noticed that they go completely wrong when calculating the numbers because of the method being used. So, in reality, the situation might be quite different. Here are a few lessons:

Lesson 1: Never take any number at face value. An investment that has gained 25 per cent or lost 50 per cent may not be the right way of looking at it. There is a need to ask questions. For instance, over what time period, what is the base from which this has been calculated and so on.

Many investors end up making the wrong assumption and the end result obviously is completely wrong. Another thing that should never be done is to add or subtract the various returns and then arrive at the net financial situation. This can also turn out to be quite misleading. 

Lesson 2: When there is a fall in the price of a share, investors start feeling jittery. The bigger the fall, the more nervousness it creates. While this means a potential loss of profits, often the situation could actually be much worse, or there could even be gains than anticipated. Anyone who knows the implication of the figures and the base involved will be able to spot the danger at an early stage.

Let us take an example. Say, an investor purchases a share quoting at Rs 25. Assume that there is a major bull run, whereby the share rises by 300 per cent. This means that the share price has become four times the initial value. That is, the share price is now Rs 100. Now, if there is a fall in the share price by 50 per cent, the investor will then find that he has lost 200 per cent from the gains made. But he is still in profits. And a good 100 per cent as well.

This is precisely what happens in most cases where some sharp corrections may not actually wipe out the entire gains. Even if the share price falls by 75 per cent, the price comes back to the original cost.

In this case, the calculations are based on the initial purchase price of Rs 25. Of course, if the investor had entered at Rs 100, he would then be sitting on significant losses.

Lesson 3: Similarly, when shares rebound, investors often find that the rise is not helping their numbers at all. That is, the quantum of loss continues to be in spite of the turnaround in the fortunes. The acquisition price just seems so far away that it might be years before this is reached again. This is the kind of situation that will be witnessed over the next several months by various investors as they come face-to-face with the losses that have actually incurred.

Consider this example. Say, the acquisition price of a stock is Rs 1,000. The market then falls and there is an 80 per cent drop in the price to Rs 200. From this level, even a similar 80 per cent rise in the price of the share will take the share price only to Rs 360 (Rs 200 base).

In fact, it would require a return of 400 per cent on the reduced price to come back just to the previous cost. In this case, the reason for such a situation is that the base for the fall is larger at Rs 1,000, while the base for the gain is smaller at Rs 200 and this leads to a larger overall loss as far as the ndividual investor is concerned.

In other words, look at numbers carefully. Sometimes, a 50 per cent fall could mean a gain, whereas in other times, even an 80 per cent rise could mean a loss.

The writer is a certified financial planner

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