Lessons from a Lifetime in the Capital Markets

“The true investment objective of growth is not just to make gains but to avoid loss.” – Attributed to Philip Fisher.

Topics covered under this Article are as follows:

1. Introduction
2. Wrong Booking of Profits/Losses
3. Avoid Sentiments in Investing
4. When to Get Out of a Losing Stock
5. Cost Averaging
6. Avoid Booking Small Profits
7. Conclusion

1. Introduction

The fundamental reason for investing in stocks is to create wealth. It goes without saying that, to create wealth, one should invest in winners and not losers. But of course, this is trickier than it sounds. The fact is that investors often choose the wrong track, sometimes out of ignorance but more often because their mindset is wrong. Even the most talented and studied investors do not buy the right stocks all the time. Mistakes are not just possible but normal. The key is to recognize the mistake, correct it promptly, and avoid repeating it.

2. Wrong booking of profits/losses

One very common mistake is booking profits in winners while keeping losers. This results from the mindset that all investments should be profitable in the end. Investors of this mindset cling to scrips that have lost value, convinced that the cost will be recovered if they only wait long enough. If, after a prolonged wait, the scrip slowly creeps up in price and passes the level of the investor’s original cost, they finally sell the scrip for a small profit, feeling satisfied that they averted a loss. In reality, they are making one of two mistakes. If the scrip was a poor choice, the investor should have sold it as soon he knew it, rather than wait (forever) for the scrip to regain its original value. If the scrip is actually a good value, it should be kept until it reaches its true potential, not sold for a small profit. A good example of this lesson is the scrip Manappuram Finance. Let us look at its price movement over a period of several years.

During the middle of 2014, Manappuram Finance was quoting around ` 35 to 40. A few months later, the scrip fell into the range of ` 20 to 25, due to some regulatory concerns and the fall in gold prices. The price remained below 30 for most of 2015, then started rising in early 2016, reaching the 35 to 40 range in the second quarter. Investors who entered the scrip in the 35 to 40 range during 2014 would have had to wait about two years to recover their cost. No doubt, many of them sold in the second quarter of 2016, when the price finally exceeded their cost. Let us now consider where mistakes were made.

When Manappuram Finance’s price collapsed during late 2014 and early 2015, investors should have opted to “stop loss” and sold the scrip, as there were serious concerns about the stock at that time. The investors who waited for cost recovery and sold in Q 2 2016 earned no return even after waiting for 2 years. As it turns out, this too was a serious mistake: after crossing 35 to 40 range in Q 2, the scrip went on to cross ` 100 during Q 4 of 2016. Thus, the investors who sold in Q 2 after finally recovering their cost achieved the worst possible outcome.

The right approach would have been to sell in late 2014 or early 2015 as soon as the mistake became apparent, or, having already waited through difficult times, to persevere until the scrip reached its true potential.

3. Avoid sentiments in investing

There’s no room for sentiment in investing. One invests in shares to make profits and create wealth. Listed shares are generally highly liquid, so if a stock underperforms, you can get out of it quickly—without incurring large exit charges. In real estate or in gold jewellery—the two other common investments for Indians—exiting can be difficult and typically involves expensive fees. In real estate, for example, transfer costs of around 8%–15% of the cost of the asset apply every time a transfer takes place. And finding a buyer for your property may take time. In gold jewellery, the making charges are sometimes as high as 10%–20% of the cost of gold, and most of this sum is lost in every transfer. In contrast, the cost of selling shares is nominal—typically a quarter to half per cent at the maximum.

4. When to get out of a losing stock

If a share investment turns bad, get out of it quickly, but only after doing some homework. If you picked up the scrip after conducting detailed research, go back to your information and see where you went wrong. If your data still seems dependable and if the scrip’s non-performance seems only temporary or is attributable to an easily resolved problem or issue, then there’s no need to sell right away. In fact, an industry leader that’s experiencing some modest, temporary trouble could be an ideal candidate for purchase. For example, in June 2015, Nestle, the market leader in FMCG segment, experienced a 10% one-day decline in its scrip after sales of its top brand, Maggi noodles, were banned due to a product defect. Maggi is sold all over the world, so smart investors should have intuited that the ban would be temporary and the product would soon be back on the shelves. Sure enough, the ban was lifted after 5 months and the product recaptured its market share in less than a year.

On the other hand, if you realize that your premise for buying was wrong or that conditions in the market have changed (as, for example, due to unexpected government policies or an unexpected problem with the integrity of the promoter), then don’t dawdle—sell the scrip. In these situations, booking loss early is wiser than waiting for the price to recover.

Another mistake to avoid is to blindly mimic others, including experts. Picking a Sensex or Nifty share based on “expert” advice may not cause you serious harm, as a share included in a major index should satisfy basic standards. But if the scrip is unknown, be extremely careful. A recent example of the risk is “Surana Solar” scrip⁵. On June 9, 2015, Exchange data showed that India’s best-known investor, Rakesh Jhunjhunwala, had purchased 2.56 lakh shares of the scrip at an average price of ` 53.74. This was big news, as the company’s financials were poor; the stock hit the upper circuit. When news reports later clarified that the purchase had been made by someone other than the well-known investor, the scrip collapsed to the lower circuit, losing more than 40% in the next four trading sessions. NSE and BSE were instructed by SEBI to withhold securities and fund payouts, pending an investigation into the matter. Thus, anyone who buys blindly, without verifying the quality or fundamentals of the scrip, is at risk.

5. Cost averaging

Cost averaging is a strategy that investors often adopt when the price of the purchased scrip falls. For example: If you buy 100 shares of a company @ ` 50, then buy another 100 shares after the scrip falls to ` 40 each, you would have a total of 200 shares at an average cost of ` 45 (100 *50 + 100*40 = 9000/200 = 45 per share). Cost averaging can be done at a higher price also, which would, naturally, result in a higher average cost than the original.

Cost averaging at lower prices is generally not recommended. A fall in price normally means something is wrong with the scrip. Why buy more of it when things are not OK? On the other hand, if you bought a scrip after proper research, and if the fall in price is caused by something that can be set right soon or is a one-time event, then a purchase may be in order. The key point here is that one should not blindly follow a principle of buying when the price falls. Buying is a serious decision in which all aspects of the case should be considered; it should not be an impulsive response to a cheap price.

6. Avoid booking small profits

A practical problem for casual investors and traders is that they end up booking small profits on good shares in order to hold onto other shares that have so far incurred losses. Investors who do this are missing the big picture. Peter Lynch, the legendary investment manager, notes that instead of rectifying mistakes, investors do the opposite by “pulling out the flowers and watering the weeds”. Lynch observes that “if you are lucky enough to have one golden egg in your portfolio, it may not matter if you have a couple of rotten ones in there with it”[1].

7. Conclusion

No one picks good shares all the time. Mistakes are inevitable, so don’t fret too much over them. The mistake to avoid is to hold your worst picks while selling your best ones. Warren Buffett remarks that “if you buy things you don’t need, you will soon sell things you need”. If a person has a portfolio of 10 scrips, it is normal to have couple of big losers, a couple of small losers, some small winners, and a few big winners. The strategy to adopt is to get rid of the losers (after examining their potential and being satisfied that their prospects are bleak), cost average the future winners, and hold onto the big winners. Over time, the profits from the big winners will be far higher than the losses you booked from the fallen shares. The winning strategy is to cut your losses early and run with the winners[2].

[1] Chennai Bureau, “Jhunjhunwala effect: Bourses withhold payouts in Surana Solar trades,” The Hindu Business Line, Saturday, June 13, 2015.

[2] Lynch, Peter, and John Rothschild. One Up On Wall Street: How to Use What You Already Know to Make Money in the Market (New York: Simon & Schuster, 2000).

• All-About Capital Gains
• Case Study on Issue of Long-Term Capital Gains on Sale of Penny Stocks under section 10(38) under Faceless Assessment
• Difference Between Long-Term Capital Gains Tax And Short-Term Capital Gains Tax
• Difference Between Capital Expenditure and Revenue Expenditure