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The Seven Deadly Sins

Low interest rates means double-digit returns are possible only by investing in equity. But with caveats.

The Seven Deadly Sins
Punit Paranjpe
The Seven Deadly Sins
outlookindia.com
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Pride, envy, anger, sloth, greed, gluttony, lust. For centuries now, theologians have debated these seven deadly sins that, according to religious scriptures, hinder the path of human beings to spiritual progress and redemption. As a group, they are no closer to arriving at a consensus on how these sins influence life and after-life than they were when they started out.

A list of transgressions, on the same theme, can be drawn up for equity investors as well, which is what we did after speaking to some of the best minds in business. But unlike theologians on their subject, our market experts didn’t express radical differences in opinion on our market adaptation of the seven deadly sins. They pretty much agreed that the avoidance of these vices by investors would go a long way in making stocks an easier, more comfortable—and more profitable—world.

With interest rates on debt instruments spiralling downwards, and Budget 2003 giving clear signals that low interest rates are here to stay, the only way to take home double-digit returns is by investing in equities, either directly or through mutual funds. As an investment, equities currently look extremely attractive given the low valuations on offer and pro-investment budgetary proposals such as the removal of long-term capital gains tax in Budget 2003. But when you do venture into the market, make sure to steer clear of these seven deadly sins of equity investing.

The First Deadly Sin: Act Blindly on Hot Tips
Company XYZ will double its profits this year.... XYZ is going to bag a huge contract next week.... xyz is being bought by its rival—if you invest in stocks, you are bound to be swamped with such investment advice, be it from the media, your broker, colleagues, family or friends. And it will usually come packaged like the ‘opportunity of a lifetime’, ‘a chance to double, triple, quadruple your money overnight’. Some of it will rest on credible information, some of it will be passed down the line in a game of Chinese whispers. Some of it will be well intentioned, most of it will be driven by ulterior motives.

There’s nothing wrong with such advice per se. However, by acting on it blindly, you could be inviting trouble. Back in the 1992 boom, investors were rushing to get a piece of nondescript companies like Mazda Industries, Andhra Cements and Karnataka Ball Bearings simply because word on the Street was that they had caught the fancy of Harshad ‘Big Bull’ Mehta. Nearly a decade later, the same phenomenon gripped the infamous KP (Ketan Parekh) stocks. When these brokers fell from grace, so did these stocks, as they didn’t have any performance-based story going for them and were thriving purely on artificial support.

In this big-stakes market, misinformation is a potent weapon for market players with financial interests to protect. Hence, always check the authenticity of the argument on which a recommendation rests and whether the stock merits investment based on its fundamentals. Avoid ‘hot tips’ that promise extraordinary returns. Nobody has made extraordinary returns from the market on a consistent basis, certainly not a small investor, who has little primary access to price-sensitive information. You should be more than happy if you get annualised returns of 20-25 per cent from stocks. And the comforting thought is that you needn’t go hunting for insider information to take home such returns; conventional tools of stock picking like fundamental analysis will serve you just fine.

The Second Deadly Sin: Chase Market Fads
Hype abounds in the stock market. When a stock or sector story becomes appealing, everyone wants a piece of the action—from brokers to operators, from established companies to wannabe promoters, from the serious businessman to the fly-by-night operator. And when you buy into a happening sector story, understand that you are stepping inside a bubble that is eventually going to burst.

Remember the dramatic rise and fall of sectors like aquaculture, floriculture, financial services and steel during the mid-nineties. There was a pattern to these boom-and-bust cycles, which was repeated during the frenzy for ICE (information technology, communication and entertainment) stocks towards the end of the decade. This is how it goes:

First, the industry leaders attract the attention of market-savvy players. As the great sectoral story unfolds, second- and third-rung counters start moving up. Soon, the me-too players surface to ride the wave of optimism. Such a broad run-up invariably leads to a short-term revival in the primary market, as IPOs from the sector in the spotlight flood the market. Eventually, reality hits—the great sector story is not so great as it was made out to be. Share prices crash, leaving behind a trail of scarred investors. While the frontrunners live to see another day, the also-rans are wiped out.

Look for value at all times, don’t go by what is ‘in’. Says Sanjiv Shah, executive director, Benchmark Asset Management Company, "It (chasing fads) is dicey. If you catch the so-called fancy first, you’re a winner. If you catch it last, you’re an idiot." When the argument ceases to rest on value and hinges on riding market momentum, the risk in your investment increases sharply. Unless you can do the first-in-first-out act, it’s best to be fearful of the flavour of the season.

The Third Deadly Sin: Borrow to Invest
When making money appears easy, there’s the temptation to try and make more, by borrowing. On paper, it looks easy: borrow money at 15 per cent (the going rate today), invest it in the market and make more than that, and pocket the difference. There’s one hitch, one big hitch. The market is a fickle beast. Stock market movements are unpredictable, especially in the short term. Says Ved Prakash Chaturvedi, chief executive officer, Tata Mutual Fund, "The market could turn against you, and stay that way for a long time. Meanwhile, you’ll still need to pay interest on your loan."

Borrowing also makes for bad economics. Today, you would have to pay an interest rate of at least 15 per cent for a personal loan, probably more if you raise it from money-lenders in the unorganised market. Now, you should take home at least 7 per cent—the risk-free rate of return, or what your money would otherwise surely earn—to justify taking on such high risk. In other words, you need to make at least 22 per cent from the market, which is difficult to do consistently. Says Asit Koticha, managing director, ask Raymond James, "As it is, equity carries risk. By investing borrowed funds, you are taking a disproportionate amount of risk in comparison to returns."

Leave such risk balancing to the traders and market pros. Stick to your own funds. Ideally, you should invest only those funds in the market you can safely set aside for at least three years. That’s because even if your company is doing well, it might take a while before it attracts sufficient investor interest for this performance to translate into stock appreciation. The trick is to invest in good companies when their share prices are depressed—now is one such time—and stay put. Sooner or later, gains will follow.

The Fourth Deadly Sin: Enter the Market for Thrills
A large number of small investors deeply misunderstand equities and the market. They tend to see it as a get-rich-quick avenue. Having read and heard spectacular success stories and seen the possibilities of overnight gains on the stock tickers that stream across the telly, they start to believe they too can make a killing. Their investment behaviour starts to reflect their narrow investment philosophy. They get drawn into the market during times of extreme bullishness. They start to speculate and try to predict the market’s mood swings. They buy on rumours. And when they fritter away their hard-earned money, they swear never to come back—till the next market boom breaks their resolve.

Booms and busts are an integral part of the market—and will always be. But to ride them for thrills would only hurt your wealth. Often, the best investment is the one you already have. Making money on the market is as much about side-stepping landmines as it is about zeroing in on the potential multi-baggers. To come through requires an understanding of how the market and businesses work.

Equities are a powerful wealth creation tool—in the long run, they have been known to outperform every other asset class. You need to treat them as such. This means practising discipline, having patience and following time-tested principles of investing. For instance, when you buy shares, don’t just see it as a piece of paper (or now, a collection of bits and bytes). See it as an instrument that gives you a stake in the company’s business. If the business grows, chances are, so will your investment. Hence, study the business, gauge its potential to grow and stay competitive, see how much of this potential growth is factored into the stock price. If you don’t feel equipped to undertake such an exercise, take the mutual fund route. Such strategies might not yield you overnight gains, but they’ll give you returns worthy of equities if you do your homework well. What’s more, you’ll sleep well at night.

The Fifth Deadly Sin: Put all Your Eggs in One Basket
Who can resist investing in a sector growing at 60 per cent a year? No investor in his sane mind would—or even should—pass up an opportunity like that. But the key is not to go overboard in this pursuit of growth. Once again, take the ICE stocks phenomenon. Those who invested early in such stocks and managed to get out before the house came crashing down would have made good money. But those who didn’t manage the great escape were caught cold. The worst hit were those who had parked a majority of their savings in ICE stocks.

Portfolio diversification is one way to lower such risk. Spreading your portfolio across sectors and companies provides you some degree of protection against adverse developments in a particular sector or stock. Says T.P. Raman, managing director, Sundaram Mutual Fund, "Portfolio diversification is good. There will always be some investments in a portfolio doing well and some doing bad."

Say you have a portfolio of Rs 1 lakh, all of which is invested in one stock, Reliance. Now, for some reason, the stock drops 50 per cent. The value of your investment will halve to Rs 50,000. But what if you had invested only 10 per cent, or Rs 10,000, of your portfolio in Reliance? Assuming that prices of other stocks in your portfolio remain the same, the value of your portfolio would have fallen 5 per cent. The opposite also holds true: if Reliance shoots up 50 per cent, the diversified portfolio will gain less than the single-stock portfolio. It’s a trade-off, but one that makes good business sense. Market experts advise having a portfolio of 7-15 stocks, with not more than 15 per cent invested in a single company and 25 per cent in a single sector.

The Sixth Deadly Sin: Buy and Forget Your Investment
Just as there’s a time to buy a stock, there’s also a time to sell. If you miss it, you might end up with substantially less than what you had bargained for at the time of investing. But it’s not something that is dictated by the calendar or can be foretold. Says Raman, "A stock is not like a debt instrument that you can buy and forget till it comes up for maturity. You have to evaluate stocks periodically."

A company, of which you own a part of, is an ongoing, dynamic entity, functioning in a business environment that is constantly changing, and you need to see it like that. That means periodically tracking its performance and prospects, and not shying away from selling in the event of adverse developments. Says Gul Teckchandani, chief investment officer, Sun F&C Mutual Fund, "Ideally, invest with a time-frame of at least three years and review the company’s prospects once a quarter." To avoid increasing your workload, don’t invest in too many companies and avoid companies whose businesses you don’t understand.

The Seventh Deadly Sin: Sell at the Highest Price
Nine years ago, Infosys made an IPO at Rs 95 a share. Those who were allotted shares could have sold at Rs 1,000, Rs 5,000 and Rs 10,000 but they still would not have exited at the stock’s all-time high, which turned out to be Rs 12,700. Having said that, even an exit in the near-about of each point mentioned above would have yielded huge returns. Those who did sell before the summit could feel remorse on what might have been or rejoice on what was. And, truth to tell, it wasn’t that bad.

When a stock is on a roll, it will throw up such teasing questions for those invested in it. Even if you feel the stock has run its course for the time being, the bullish fervour surrounding it will plant a seed of doubt on whether you are selling yourself short. This cycle of doubt can backfire, and you could end up where you started from.

It’s near-impossible to time the market, or to buy a stock at its bottom and sell at its high. Share prices are driven by myriad factors, like demand-supply dynamics, company performance and investor perception. Once your target value is realised or the basis for holding the stock has changed, sell it. Says Teckchandani, "It helps to have rigid price targets to decide on exit points. Valuations are relative, and such a strategy helps in cutting greed." Which brings us back to where we started from eliminate tendencies grounded in greed and emotion from your investment decisions, and you are on your way to giving your stock a leg-up.


Budget Impact
Tax-free dividend for shareholders; a 12.5% distribution tax on firms

No long-term capital gains tax on investment in listed equities from Mar 1

A commitment by the FM to bring small investors back to the bourses

Legal amendments in Parliament to corporatise stock exchanges

Major review of the current sectoral limits for investments by FIIs

The process of FIIs’ registration to be streamlined to facilitate their easy entry


By Avinash Singh with Sagar Patel

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