Chapter 5: When the going gets tough, do nothing

Edward Kennedy 'Duke' Ellington was a well-known jazz pianist who later became a famous composer and bandleader. Considered by many to be one of the foremost influences in jazz music, his complex compositions and arrangements brought jazz to the mainstream of American music.

Several of his compositions have become jazz 'standards' - recorded and performed by a whole host of singers and musicians through the years. Some, like 'Caravan', became so popular that even pop instrumentalists performed and recorded the song.

One of Duke's compositions - 'Do nothing till you hear from me' - has relevance to the current state of the Indian stock market, if you replace 'me' with 'Mr Market'!

With the market hitting new highs every day, many small investors are utterly perplexed about what to do. Some feel this is a great time to buy. Others had seen their portfolios erode away in the bear market and are waiting for the next big correction to enter again. The more adventurous ones are writing puts and calls and probably making their brokers rich! Risk-averse investors are looking at bank fixed deposits and company deposits. But the really smart ones are riding out the market turmoil by doing nothing.

An avid mountain climber once commented about his frequent attempts at climbing the Everest: “I try to climb the Everest because it is there!” Well, the stock market is very much there - and will be there for quite some time longer! Does that mean that you should always be buying and selling?

Remember, 'do nothing' does not mean 'remain completely inactive'. This is a great time to do fundamental analysis of companies. Find out which ones are offering greater value in terms of dividend yields, price to book value ratios, operating cash flows, profit margins.

Make a short list of such companies and track them on a daily basis. Then wait to hear from ‘Mr Market’. He will start giving you diverse and interesting clues - such as, changes in interest rates, a decrease in the advance-to-decline ratio, an aversion to discussion about the stock market among your market-savvy friends.

The cumulative effect of such clues will indicate that the correction may be around the corner. Till you hear from me (I mean, ‘Mr Market’), take your spouse out for a candlelit dinner, take that dream holiday to Mauritius or Machu Picchu but do nothing about buying or selling in the stock market. If you absolutely must buy or sell, at least wait for the quarterly results before doing so.

Chapter 4: Don’t be a bull or bear in the Stock Market

The triangular headed South African python is a truly awe-inspiring reptile - massive in length and weight, immensely strong with an intricately patterned shining skin. The other day, on the National Geographic channel, the camera followed such a beauty as it slowly slithered through the bushes and weeds and glided into a watering hole.

There it hid with only its snout above the water - and waited patiently. Day followed night and night followed day - and still it waited. Animals big and small, frisky and sloth, came to the watering hole for a drink. The python didn't move.

Six days and nights passed - and no one except the camera-person knew that the python was lying in wait. On the seventh evening a herd of deer came for a drink. A younger member ventured a little further in from the water's edge - unaware of the peril.

Suddenly, the water hole exploded into action. With its immense muscle power, the python lunged out like greased lightning and in the blink of an eye had wrapped itself around its prey. The poor animal probably didn't even know what hit him.

The South African python is used to spending weeks and even months without feeding. Some times it eats the odd rodent or bird. But when it really wants to eat, it plans its every move and with infinite patience grabs a large meal so that it won't have to eat for a long time.

Like the python, a successful long-term investor does not need to 'feed' (i.e. trade) every day or every month. Once in a long while, the stock market provides an ideal opportunity to grab a few frontline stocks at mouth-watering prices. Back during the 2002-2003 bear market period, stocks like Tata Steel was available at 100, M&M at 90, ITC at 60 (actually 600 for a Rs 10 share). All three subsequently offered bonus shares at 1:2, 1:1 and 1:2 ratios respectively.

There were many other shares going for a song and which made a ton of money for savvy long-term investors. Since then, there was a one-way bull-market with V-shaped corrections in 2004 and 2006. But after 5 long years there was a full-fledged bear market from January 2008, which ended in March 2009.

For long-term investors, the period from January 2008 to March 2009 was the right time to behave like the python. Not to jump in, but to conserve their muscle power (i.e. cash), decide on a few target companies and wait patiently for the market to start rising.

Chapter 3: What are your Future Options?

A British schoolboy cricketer had once approached Sir Geoff Boycott to learn how to play the hook shot. Boycott told him that the best way to play the hook shot was not to play it!

"But how do I score runs?", the boy had asked. Boycott's response was typical: "Don't get out! The runs will come.”

Futures and Options (F&O) trading by small investors are akin to a young cricketer playing the hook shot. The chances of losing money overshadow the probability of scoring big. It is far better and safer to buy quality stocks and wait for your wealth to grow.

Nowadays the lot sizes for F&O trading have been reduced, but the risks have not. Such trading is better left to professional and institutional investors who play for much bigger stakes and usually buy or sell in the cash market and hedge in the F&O market.

There is no harm in being aware of what F&O trading is all about, and some smart investors can get clues about the market levels from the open interest volumes and the difference between spot and future prices. But I get confused when I hear talk about 'covered calls', 'strangles' and 'naked futures' and have stayed far away from F&O trading.

Seems like I'm not in a minority of one. The legendary Peter Lynch has made the following comments in his book ‘One Up on Wall Street’:

"I've never bought a future nor an option in my entire investing career.... Reports out of Chicago and New York, the twin capitals of futures and options, suggest that between 80 and 95% of the amateur players lose. Those odds are worse than the worst odds at the casino or at the race-track, and yet the fiction persists that these are 'sensible investment alternatives'.... I know that the large potential return is attractive to small investors who are dissatisfied with getting rich slow. Instead they opt for getting poor quick.... Warren Buffet thinks that stock futures and options ought to be outlawed, and I agree with him.”

Chapter 2: How to lose less with a Stop-loss

"More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason" - Philip A. Fisher.

You should re-read the quote above. If you have been investing in the stock market for any length of time, you have surely succumbed to the 'coming out even' fallacy at least once.

Truth is, ‘Mr. Market’ does not know at what price you bought a stock or fund. Nor does he care. But you do, and that is the root of the problem.

I'm presuming that you performed due diligence in selecting a particular stock or a fund - carefully studying past performance, dividend records, peer comparisons. And yet, in spite of your best efforts, you pick a loser. It happens. All a part of the game.

This is when your investing mettle will be tested. Will you swallow your pride and get out? Will you soldier on, 'knowing' that you've picked a winner that will surely make you rich soon? Or will you become a 'long term investor' simply because your short-term plans have got nixed?

A neat little device, called a 'Stop-Loss' level, may save you the blushes. How does it work? Before you buy a stock or a fund, you should decide how much loss you will be able to tolerate. For an expensive stock, your loss tolerance may be less. For a cheaper fund it may be more.

As a conservative, long-term investor, I like to set a stop-loss level of between 15% and 30% of the buy price.

Let us say I'm planning to buy a stock for Rs. 100, and set the stop-loss at 20%. If the stock falls to Rs. 80 or below, I'll not wait and sell immediately - thus ‘stopping my loss’ at Rs. 20 per share.

What if the stock price rises to Rs. 120? Do I have a huge grin on my face and brag about my stock-picking skills to all and sundry? I'll be lying if I said, 'No'. But what I also do is set a 'trailing stop-loss'.

What's that? It means increasing the original stop-loss level by the same percentage as the rise in the stock's or fund's price. In our example, we will raise the stop-loss level to Rs. (120 - 24 =) 96.

If the stock moves up to Rs.200 (this happens usually in bull markets - but also some times in sharp bear market rallies), the stop-loss level will now be Rs.160.

Stop-loss levels not only help you to limit your losses, but a trailing stop-loss will protect your profits as well. Should the stock price suddenly fall to Rs.150, your stop-loss level will be 'triggered' and you will sell off, still making a profit of Rs. 50 per share (that you bought originally at Rs. 100).

The foregoing discussion has been written from the point-of-view of a conservative long-term investor. I have nothing against those who trade stocks on a daily basis, but I do not recommend trading to new or inexperienced investors. But if trading is what gets you excited, you may want to set 'tighter' stop-losses.

In the 2008 bear market, the Sensex fell more than 60% from its January 2008 top of 21200. But many small investors were facing much bigger losses because of their penchant for buying smaller and ‘cheaper’ stocks and funds.

The two lessons from such a traumatic experience are:

(1) most stocks or funds that seem a bargain are not; better stick to proven performers and market leaders;

(2) even if you've chosen the wrong stock or fund, applying a disciplined stop-loss mechanism will limit the losses.

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.

How to become a better investor - Introduction

There were three reasons why I started to write an investment blog in June 2008.

First, the stock market was in the throes of a severe bear market after 5 years of euphoria. I remembered the boom and bust during the Harshad Mehta scam in 1992 and how traumatic it was for me. I felt that sharing some of my experiences in the stock market could help young investors to learn and avoid the mistakes I had made.

Second, while there are a plethora of web sites and blogs that offer stock tips, I failed to find a single web site or blog that educated investors by explaining the concepts behind fundamental or technical analysis in simple language, with examples from the Indian stock market.

Third, the blogging platform offers instant reach to an audience, and allows quick two-way communication with readers - thanks to the proliferation of the Internet. That helps in regularly guiding, resolving doubts of, and learning from, investors.

I had to struggle during my early investment days in the 1980s. There was no Internet and no SEBI regulations and no business TV channels and no quarterly reporting by companies. The only way to find out about companies was from brokers or friends. The only way to know what price a stock was trading at was to call your broker and accept whatever he said. Charting had to be done manually on a graph paper after prices were published in the next day’s newspapers.

Things have changed quite a bit since then – mostly for the better. If there is a problem now, it is an overload of information and stock ideas! Investors are better informed and better educated. Still, investment psychology – particularly the extremes of greed and fear during bull and bear phases – remains pretty much the same. At every market peak, a new lot of investors keep jumping into the market without adequate homework, only to lose their hard-earned money.

So, my effort at investor education through my blog continues. Many of my readers have been urging me to prepare an eBook using my blog posts, so that they can easily refer to some of the posts without wading through my entire blog. They have motivated me to produce this eBook, and I hope they would not mind if I don’t thank them individually.

The effort took longer than I had expected, and for reasons of brevity, I have chosen a few posts from the period June 2008 to January 2009. Hope readers of this eBook will learn to become better investors by reading it.