Stock market indicators are often considered the barometer of an economy. With these indicators at new highs, investors’ market participation has risen considerably. Investors make rational decisions in other aspects of life, but they often make errors of judgment when dealing with money, especially equity investing. Let’s discuss some common mistakes to be avoided.

Avoid the ‘no policy’ style
There is a strong correlation between risk and return and everyone agrees that, often, high risk leads to high returns. However, a clearly planned investment policy provides high return with low risk. Most of the times, people invest in the market either without an investment policy or with a vaguely constructed one. An ambiguously conceived investment policy impairs sound investment decisions.
Hence, it is essential to have a clear- cut investment policy that indicates general investment goals and documents the specifics, such as asset allocation, risk tolerance and liquidity requirement.

Don’t put all eggs in one basket
Often, investors assume that by focusing on one ‘hot’ sector they can maximise returns. Suppose the government announces an excise duty cut for the tyre industry. Such investors will focus on accumulating tyre stocks, assuming the good news will shore up prices. But, often, the stocks do not move the way you want them to — that is probably already factored into the prices. Clearly, then, lack of diversification can lead to poor performance for the entire portfolio.

Don’t lap up all at one go
Suppose you have identified a company based on your valuation computations. In such a case, don’t buy all the shares at one go. For instance, if you plan to buy 1,500 shares of ABC, buy 500 shares and wait and watch a little. Of course, there is a risk that the stock will go straight up, leaving you with foregone profit on the additional 1,000 shares. But that’s not usually how it goes. It is advisable to get in and get out in instalments.

The eternal wait for a comeback
This is another common mistake that investors commit while buying and selling. Suppose, based on an analysis, you wish to sell ABC at R450, but somehow you fail to do so. Thereafter, the stock starts falling, owing to general market conditions and changes in company fundamentals. An investor waiting for the price to come back might still be waiting at a price of, say, R26, irrespective of the fact that R450 is completely unlikely.

The takeaway: If the price of a stock has gone up or down due to a change in the prospects of the company or the sector, the belief that the price wil come back to the old level is just an illusion.

Thinking this is the ‘bottom’
This is another serious mistake. For instance, XYZ might have fallen significantly, leading the investor to believe it cannot fall further. This can lead to huge losses. Suppose XYZ falls from R540 in January 2014 to R230 in March 2014, a massive 57% drop in two months. If an investor believes it cannot fall further and holds on to it, or accumulates even more, imagine the outcome if the stock falls to to R20 by November 2014. That’s a massive 96% decline from the January level and a 91% fall from the March level.

Unless the stock becomes attractive on a standalone basis, either on fundamental or technical analysis, there is no logic in believing it cannot fall further.

These are some avoidable mistakes investors commit with stocks. A simple, logical computation works far better in the market rather than complex valuation models. Investors need to use common sense, logical thinking, patience and perseverance to be successful in the stock market.

Wealthwise

  • Have a clear-cut investment policy that indicates general investment goals and documents the specifics such as asset allocation, risk tolerance and liquidity needs
  • Often, investors assume that by focusing on one ‘hot’ sector they can maximise returns. A lack of diversification can lead to poor performance for the entire portfolio
  • If a stock has gone up or down due to a change in the prospects of the company or the sector, the belief that the price wil come back to the old level is just an illusion
  • Unless the stock becomes attractive on a standalone basis, either on fundamental or technical analysis, there is no logic in believing it cannot fall further

The writer is associate professor of finance and accounting, IIM Shillong