Saturday, December 31, 2011

Chapter 1: How to lose money and become a better investor

There are only two rules of investments (as per legendary investor Warren Buffet):

Rule number 1: Do not lose money

Rule number 2: Read rule number 1

Such great advice is totally inappropriate for those who are investing in the stock market or mutual funds for the first time. It is almost like saying "Do not fall down" when learning to ride a bicycle. Just like you will fall down a few times before you learn to ride a bicycle, you will lose some money before you learn how to invest in stocks and mutual funds.

In fact, losing money is an essential part of learning to become a better investor, though this goes against the grain of logic.

When you begin making your initial foray into investments, chances are you will not have too much cash in hand. So going to an investment advisor wouldn't make much sense. You will end up going to a relative or a friend - whom you consider to be an expert - and ask for tips or ideas.

Despite the best intentions of all concerned, the first couple of investments will probably go sour. Even if the investments actually generate a profit on paper, you may not be able to take that profit home because you will not know when to sell!

You may be among the unfortunate many who got caught up in the buzz of the Sensex hitting 20000, and jumped in to the market in January 2008 - when all the excitement and euphoria was at its peak. That means you are probably still sitting on substantial losses.

Shortly afterwards, the market began to drop and you were left holding your investments at higher prices - not knowing what to do. When the market dropped some more, you got into a panic and called your friend or relative for advice.

Chances are, the advice was: "Hold on a little longer; the market will rise again - sell then." The market did rise but not to the level at which you entered. You may have held on, hoping to get back your ‘buy price’ and break even.

That was just the time for you to turn your ‘paper’ losses into ‘cash’ losses. Which means actually selling the shares in which you were losing money instead of holding on to them. Why would you do such a 'foolish' thing? Because you never know how low the market can go, and when it will rise again.

If you buy a share at Rs 100, and it falls to Rs 50, you lose 50%. But if you hold on expecting to sell when the stock reaches 100 again, you are expecting a 100% rise in the stock price. Not impossible but highly unlikely.

If the stock falls further to Rs 33, your loss is 67% but to get back your original Rs 100, the stock has to rise 200%! (Do not use such 'opportunity' to buy more. Your average price may go down, but your losses will keep increasing.)

So you decide to 'book' your losses. Now what should you do with the money? Do not reinvest it back in the market right away. Put it in a short term fixed deposit or a Liquid Mutual Fund, and watch the Sensex move back up before re-entering.

A better investor will quickly learn the concept of a 'stop loss' - a price below which (s)he will 'book' losses and get out. Setting a stop loss is an art, and will depend on your risk taking ability and your conviction in the quality of the stock.

A timid investor will run away from the market after such a money-losing experience and put the money in a bank - where inflation will eat away a major chunk. A smarter investor will decide to buy some books and interact with experienced investors to learn more about the subject. And he will already be on the road to become a better investor.

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