Common Stocks – Common Mistakes

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. I try to explain and explore the 10 most common mistakes which investors commit while investing in common stocks.     

Mistake 1: Trying to catch the top and bottom

This is one of the most common mistake while investing in equities which most of the investors commit i.e. trying to catch the top and the bottom little realizing 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. But, once you determine the “correct price” for a stock to buy by whatever method you may follow and once that price approaches then don’t wait to “buy at the bottom” because you will probably never be able to do that. Remember 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 of the 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, then 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 whatever kind of analysis he / she might have done 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 – cant 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 cant fall further because it has fallen 45% in 2 months and 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 fundamental or technical or whatever analysis you may believe in, there is simply no logic in believing that “because it has already fallen so much and therefore it cant fall further”.

Mistake 4: Already risen so much – cant 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 8 times in less than 2 years. Anybody, thinking that the stock has risen so much and therefore cant 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

Many readers might not agree with me on this point. Unless you are a short term trader or investing on costly leveraged funds, there is no point in simply 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”. Lets continue with the above example of Titan. After multiplying by about 8 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. 4 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. Lets 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, remember that 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 in fact 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 and 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 atleast 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. Remember, 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, - utilize the proceeds from sale to buy better investments with potential of price appreciation in future.

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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 loose self confidence and start believing that you are wrong. Remember that market can be wrong and is infact 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 loosing your self confidence.    

Mistake 8: Efficient Market Theory

Don’t blindly believe in the efficient market theory – infact remember that market is inefficient for almost 95% of the time – its 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). And if the market was indeed always efficient it would simply be impossible for so many investment gurus and fund mangers 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. And the another person in the market is the investment guru or fund managers etc. Kindly note, that 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 in totality beat the whole market on a continuous basis because they only make up the market. Simply put, everybody cant beat everybody – for there to be a winner, there has to be a looser also. And kindly note, 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 infact wrong! So don’t trust any of the so called Investment gurus as face value (including myself although I don’t claim to be any investment guru but just a student of investing).

Mistake 10: Penny Stocks

This is another common mistake which most of the investors commit – buying into penny stocks thinking that the price is already “so low”, most probably in single digit, little realizing their own thinking folly. 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.1000. Therefore, if a Re.1 stock falls to 10 paise or a Rs.1000 stock falls to Rs.100, the loss is 90% in both cases. And most importantly, if you invest say Rs.1000 in either of the above mentioned two stocks and both of them suppose become zero, then you loose your full investment of Rs.1000, irrespective of the initial price of the stock. So, 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. Kindly note, that simple logical things work far better in the market place rather than complex algorithms, theorems, valuations principles, DCF etc. And 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, its 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.

Unfixed Returns from Fixed Income Funds

Have we ever taught how fixed are the returns from Fixed Income or Debt Mutual Funds. Fixed Income funds invest in fixed income securities. However, the irony is that the name is only fixed but the returns are certainly not fixed in any of the fixed income funds. To understand the risk of investing in fixed income funds we have to understand the risks of securities in which they invest. The common risks associated with fixed income securities are credit risks, interest rate risks, liquidity risks, basis risks, yield curve risks etc. Most of the risks are well understood by the investor community and even so if not understood then they don’t necessarily need to understand them because the fund manager will manage those risks on the investor’s behalf. However, the risk that most of the investors don’t understand and which they need to understand is the “interest rate risk” because that is the risk which the fund manager manages but the investor actually decides when and how to take. When investing in an equity fund, an investor has to first decide which level of the market to invest and then which fund category to invest like index, diversified, large / mid / small cap fund, sector specific fund etc. Similarly, while investing in a Debt Fund, an investor has to decide when to invest – in essence at what level of interest rate to invest and then which scheme to invest in – FMP, liquid fund, ultra short term, short term, income funds or gilt funds etc. The investor will be able to take an informed decision on which debt fund to invest and when in a more educated manner if he understands and appreciates the key risk affecting Debt funds i.e. interest rate risks. This article will briefly explain the highly difficult and mathematical measurement of interest rate risk in simple terms and then guide you in which category of debt fund to invest during each phase of the interest rate cycle.

A long term Government of India Security (GSec) may have zero credit risk (because the Government can literally “print notes” and pay back the loan), but it has one of the highest interest rate risks. Interest rate risk is directly related with the maturity of a security. Now, I will touch upon two very important contributors of interest rate risks in this note – duration and convexity.

Duration

I have seen many investors confuse duration with maturity. However, they both are distinctly different. Maturity is simply when the fixed income security will mature and pay back the principal. For example, the maturity of a 10-year paper will be 10 years at the time of issue. On the other hand, duration is the time within which the investor receives back all the cash flows related to the security i.e. interest and principal. For example, if there is a 10-year maturity paper paying yearly coupon at the interest rate of 8.0% p.a. issued at par (Rs.100) will have the following cash flows, 8 + 8 + 8 + 8 + 8 + 8 + 8 + 8 + 8 + 108 which will be paid at the end of every year for the next 10 years till it matures.  The Rs.8 is the interest at 8.0% p.a. on Rs.100 par value. Kindly note that at the end of the 10^th year the investor will receive Rs.108 i.e. Rs.100 of principal + Rs.8 of the 10^th year’s interest. This example clearly shows that although the maturity of the security is after 10-years, the investor receives cash flows frequently at regular intervals much before the final maturity of the security. That brings me to the concept of duration. The duration of a bond is defined as the “weighted average term to maturity of a security’s cash flows”. Since the cash flows on a security are received piecemeal before the actual maturity of the security, the duration of all coupon paying bonds will be less than its maturity. And as a Zero coupon bond does not pay any interest during its life, its duration = maturity.

There are different forms of duration. The basic one is the Macaulay or unadjusted duration. The one which we use for our calculation is the adjusted or Modified Duration. I would not go into the mathematical formulae of computing these but will explain the concepts which are necessary for understanding interest rate risks associated with fixed income securities.

Duration is useful primarily as a measure of the sensitivity of a bond's market price to interest rate (i.e. yield) movements. It is approximately equal to the percentage change in price for a given change in yield. For example, for small interest rate changes, the duration is the approximate percentage by which the value of the bond will fall for a 1% per annum increase in market interest rate. So a 10-year bond with a duration of 7 years would fall approximately 7% in value if the interest rate increased by 1% per annum. In other words, duration is the elasticity of the bond's price with respect to interest rates.

Convexity

Duration is a linear measure of how the price of a bond changes in response to interest rate changes. As interest rates change, the price does not change linearly, but rather is a convex function of interest rates. Convexity is a measure of the curvature of how the price of a bond changes as the interest rate changes. Convexity deals with the curvature of the price / yield relationship or chart. Specifically, duration can be formulated as the first derivative of the price function of the bond with respect to the interest rate in question, and the convexity as the second derivative.

Convexity also gives an idea of the spread of future cashflows. Just as the duration gives the discounted mean term, so convexity can be used to calculate the discounted standard deviation, say, of return.

Note that duration can be either negative or positive depending on the way the interest rates move but Convexity is always a positive feature of the bond. The exception to this rule is in the case of “callable bonds” where the convexity is a negative feature. By positive feature of convexity I mean that for a given change in interest rates and the modified duration of a bond, the change is price of the bond will be in favour of the investor. For example, because of the positive feature of convexity, when interest rates rise, the price of the bond will fall less than that indicated by the duration and when interest rates fall, the price of the bond will rise more than that indicated by the duration. This is because when we study the price / yield relationship of a coupon paying option free bond, the larger the increase in the YTM, the greater the magnitude of the error by which the modified duration will overestimate the bond’s price decline; the larger the decrease in the YTM, the greater the magnitude of the error by which the modified duration will underestimate the bond’s price rise.

Interest Rate risk and selection of different Debt Funds

Now, let us understand at what point within the interest rate cycle it is ideal to invest in which category of Debt Fund:

Ø       Fixed Maturity Plan: A Fixed Maturity Plan (FMP) is for a fixed period of time and hence locks in at the prevailing interest rate for that period of time and therefore does not have any interest rate risk. However, the FMP has a very high “opportunity loss risk” in the sense that if you lock in long term FMP just before the beginning of an interest rate hike cycle then you will loose the opportunity of earning higher yields. Therefore, investment in a FMP should ideally be done at the peak of the short term policy hike interest rate cycle. Currently, we are at that point of time and hence an ideal time for locking in long term funds into FMPs so as to lock in at high yields.

Ø       Liquid Funds: These are for parking surplus funds for meeting the liquidity needs and hence interest rate considerations are not to be taken in them.

Ø       Ultra Short Term Funds: If the liquidity need can be stretched to a couple of weeks, then the interest rate risk in the ultra short term will smoothen out and most probably give better returns then a liquid fund.

Ø       Short Term Funds: These should be considered when there has already been substantial hike in short term policy rates and importantly this should have resulted in the yield curve being inverted or flat.

Ø       Income Funds: These funds would become attractive when there has been substantial hike in short term policy rates and importantly the yield curve is steep or atleast upward sloping and the spread between GSecs and Corporate yields are high.

Ø       Gilt Funds: These funds would become ideal when there has been substantial hike in short term policy rates and importantly the yield curve is steep or atleast upward sloping and the spread between GSecs and Corporate yields are low.

Kindly note the difference between when to invest in short term, Income or Gilt Funds – all the three after substantial hike in short term policy rates but short term funds when the yield curve is inverted or flat, Income funds when the yield curve is steep/ upward sloping with high yield spreads as compared to GSecs while Gilt Funds when the yield curve is steep/ upwards sloping with low yield spread as compared Corporate bonds.

Conclusion

The decision of when and in which scheme of a Fixed Income Fund to invest is of paramount importance for enhancing returns from your Debt Allocation because the name is only fixed while the returns are certainly not fixed. If you follow these simple principles then you would be able to generate above average return from your Debt Allocation which will many a times even put your equity portfolio into envy!