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Small investors get carried away and commit blunders when markets are peaking
Dalal Street is riding a tsunami of emburance. Before you also get carried away, remember that the biggest investing mistakes are committed when markets are at their all-time highs.
Here are seven mistakes that small investors often commit.
Speculate With Derivatives, Exotic Products
Legendary stock investor Warren Buffett calls the futures and options segment weapons of mass financial destruction. Derivatives are meant for hedging by institutional investors and high net worth individuals. Retail investors who use these instruments for speculation are only courting financial disaster because F&O trading is not suitable for everyone. Investment in equity itself is risky and F&O is mathematically 5-6 times riskier. One false step and your net worth can get wiped out.
Small investors do not have the necessary knowledge and temperament required to make money out of these complex products. Anybody who is serious about building wealth from stocks should stay away from these instruments.
Buy Momentum Stocks And Obscure Scrips
Just as a rising tide lifts all ships, the surge in the stock market has boosted all stocks in the past 2-3 months. Some penny stocks and obscure scrips have risen by over 100-200% in the past three months. If a stock was priced at 2-3 about three months ago, there must have been a good reason for it.
The market obviously didn't see value in the stock. Don't get swayed by the momentum when you go shopping.
Study the fundamentals and if what you see isn't quite rosy, avoid the build assets that you can't immediately afford. A home loan is always a good idea because the value of the asset rises over time. But using borrowed funds to buy a risky asset such as stocks can be ruinous. If the markets decline, it can deal a double whammy on your finances. You have to pay interest and also suffer a loss.
Borrowing should be determined by your ability to repay, not by your bet on the asset.
Think They Can Outperform Mutual Funds
If the average small investor does a comprehensive study of his equity portfolio he will discover that his gains from direct stock investments are nothing compared to how much the average mutual fund made during the period. Mutual funds have full fledged research team that look into every aspect of a stock before they include it in their portfolios. They are able to zero in on a multi-bagger much before that stock comes into the limelight. If you outperformed the mutual funds, you are in the wrong profession and should join a fund house as a fund manager. Otherwise, just invest through mutual funds for steady wealth creation.
Take Exposure To A Few Stocks
Even if you want to invest in stocks directly, follow the diversification principle of mutual funds. You may not be able to manage a portfolio of 30-35 stocks like a mutual fund, but you should spread the risk across several stocks. Even the best of stocks and the most promising of sectors can sometimes go into a tailspin. Infosys is a recent example. It's a good company, the IT sector is doing well and the future looks bright. But the exit of top level managers sent the stock into a tailspin in March this year. The IT belwether fell from 3,800 levels in March to below 3,000 in May. The stock price has bounced back a bit now but is still below the March peak.
Small investors should not take concentrated exposure to a couple of stocks. Contain the impact on the portfolio by diversifying your holdings across a basket of 8-10 stocks from different sectors.
Invest Huge Sums At One Go
The diversification is also necessary across time. In mutual funds, the SIP arrangement helps the investor diversify his investment over time. In stocks, you will have to adopt a patient strategy of buying on dips. Say, you intend to buy 300 shares of a particular company. Split the purchase into 5-6 tranches spread over time.
Individual stocks are more volatile than mutual funds and there will be plenty of opportunities to buy at lower prices in the coming months.
Don't think that this is the last chance to buy the stock at this price. stock. A bad stock will remain a bad investment even if you had bought it when its price had hit rock-bottom.
Now, when the price has risen too high, such stocks have become twice as risky. Sooner or later the fundamentals will catch up with the price and your investment will suffer.
Take A Short-Term View Of The Markets
Some analysts have predicted that the Sensex will touch 30,000 by the end of the year. Their prediction may well come true but don't bank on it. Despite the widespread optimism and enthusiasm about equities, there is no guarantee that the market will deliver 20% by the end of the year. There is also no guarantee that there will be no hiccups in between. Markets will go up, but not in a straight line. The stock market is not a gambling den where you can make big money overnight. This volatility is inherent to stocks. Enter only if you can stomach the risk. Also, don't enter the equity market if your investment horizon is less than three years. That is the minimum time that a new government will require to clear the mess left behind by the UPA government.
Invest More In Stocks Than You Have
While F&O can be disastrous for small investors, margin trading is no less dangerous. It is a leveraged position that involves putting at risk more money than you can spare. Brokers encourage investors to use margin money for trading in stocks. It's understandable why brokers want you to trade more. The brokerage you pay for every trade is their bread and butter. Banks and NBFCs also encourage investments. They tell you to unlock the value of your assets by taking a loan against shares, funds, bonds and deposits.
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