Human psychology is a powerful force and spoiler, especially in investing. We tend to glorify our successes and ignore mistakes or best give it a passing reference in coffee tables. Stock market investing is treacherous and requires strategy and monitoring. Even if your strategy is subpar, a good monitoring system can save the day. On the other hand, a great strategy with subpar monitoring can be disastrous.
So long as we earn money, we are savers and investors. Hence, it may be worthwhile to recount some of the mistakes I have done while handling my savings, especially in stock markets. Let us see what those mistakes are.
1. Not having Endurance
Markets are by nature volatile and hence make your emotions swing. It is normal to get upbeat in a bull market (and laud your expertise) and disheartened in a bear market (and curse bad time and luck). However, what is critical is your endurance during the down market where your emotions are tested to the hilt. I remember buying some of what is called today as blue chips way back in 1990’s when I stepped into a career. If only I had the endurance to have held them today, I could have retired a while ago! Instead, I gave into the market psychology of selling when everyone was selling. Sometimes, your investments go nowhere though they are not producing any losses. They can test your patience since you will have the urge to compare them with broader market or with other stocks. Stock price appreciation can never be a straight line. Many stocks have a long time period of flat performance and then a takeoff (what I call as inflection point). But the point is we cannot predict when that take off will happen. Since we cannot predict this, we sometimes lose interest and exit the investment. That can prove costly as well. Here is an example of Eicher Motors. Notice the long stretch of flat stock prices (2001 to 2009) hovering between Rs.24 and Rs.400, and then a sudden burst of performance taking the stock price all the way up to Rs.21,000 within a short span of time. If you were holding this stock since 2001, it would have really tested your patience!
2. Going by the Herd Mentality
Identifying investment opportunities is a time consuming and lonely work. It requires validation from several fronts including financial analysis, qualitative analysis and connecting all the dots that are strewn all over the place. Even then, one cannot be sure about the future prospects as on the date of investing. However, there is an easy way of doing all this. Just go by what your friends/colleagues/relatives are doing or what your brokers recommend. If they are buying ITC, so buy it. If markets are going up, keep buying when the trend is positive regardless of whether valuations are reasonable. This is a sure recipe for underperformance. I used to compile the top holdings of all the leading fund managers to see where they are investing in order to mimic their investments only to realize that such a strategy is very similar to herd mentality which the fund managers themselves are suffering from!
3. Mistaking name/brand for profits
The key indices (like Sensex and Nifty) are always dominated by large caps. By definition, most of them would be market leaders in their respective industry (Bajaj Auto, Infosys, Reliance, HDFC, ITC to name a few). Market leaders are big brand owners. But being big and owning sexy brands do not equate to good performance all the time. Sometimes, it is the small seemingly boring businesses without any recognizable brand power that can create enormous shareholder wealth, which is what we are concerned. Also, once a company becomes large cap and brand leader, it may unnecessarily spend loads of money to keep that status which can be a big negative for shareholders. No wonder, many of the large caps in the index have poor performance track record during the last 5/10 years in terms of creating shareholder wealth.
4. Not acting when I should Have
It is said that the easiest thing in the stock market is to buy and the toughest is to sell. You will be forced to take a sell decision under three scenarios i.e., when you made good money and wondering if you want to take some profits, when you have lost significantly and wondering if you should cut further losses or when you have a liquidity need where you are forced to sell regardless of the situation. The first is a good problem to have and the third is a bad problem to have. However, the trickiest part is the second. This is where psychology comes and acts as a spoiler. When your investment is down, your psyche refuses to accept it as you feel you have grossly erred in your judgment. And also, there is this innate feeling that this is temporary and the value will come back. This feeling need not be backed by any logic. It can just be a feeling. Also, you have a reference point i.e., your purchase price and your psychology is swayed by this reference point. Unfortunately, the market does not know or does not care what your reference point is. Hence, once the investment goes down in value, it need not come back (as you innately feel). Rather it can go down even further. I remember being caught in one such investment cycle where I invested in a gulf stock called Gulf Finance House (GFH). Relative to my investment value, my realized loss on that investment was 98%!. A classic example of not acting when I should have.
5. Averaging on the Downside
This probably counts as a very common reaction when your investment value is down. When the stock price tumbles, instead of fearing further downside our instincts let us think that “if it was attractive at the earlier level when I bought, it should be even more attractive now, so let me buy more”. Again the spoiler in this situation is the reference point, which is your initial purchase price. Your reference point has no reference value for the market and hence averaging down on the downside can only result in “throwing good money after bad”. Since markets are volatile, bounce backs are common and can make you feel that you let a great opportunity to average your purchase price when the bounce back happens. However, if price bounces back it will also make your investment look good and hence should be of less worry. But if your averaging down does not pay off, the net loss on that investment will be manifold. Hence, the need to wait for the right price to buy stocks so that we are not caught in this dilemma of “double down”! I am appending a table to illustrate this effect. During the last one year, Nifty has been doing poorly so much so that out of 50 stocks in Nifty 43 of them are in negative territory. All these 43 companies are ripe for “averaging down” concept. The worst performer in Nifty during the last one year was BHEL with a 61% fall in share price. The stock price plummeted from Rs.270 to about Rs.100 now. Any averaging along this path could have produced endless pain. The same can be observed with other indices of NSE as well.
6. Not being affected by loss on profits
Not all losses are same. A loss of capital can produce more pain relative to say loss in profits. Hence, complacency to deal with losses in the second case. We panic the moment we have a loss of capital. But we do not show the same panic when our profits are reduced though in theory a loss is a loss. At least, that is how I dealt with my losses worrying the most in cases where the capital is negative and not worrying about those where it is a loss in profit situation. The best way to deal with this problem is to equate your year-end market value to 100 and look at the appreciation/depreciation from that perspective. Appended is a table with some hypothetical numbers to explain the concept. If your investment starts at 100 and in a 5-year horizon touches a peak of 150 and reverts back to 100, your compounded annual growth rate (CAGR) will be 0 with no negative performance highlighted in the interim 5 years. Since you don’t see any negative performance, you may turn complacent to loss in profits. However, if you equated the year end value to 100 every year, years 3,4,and 5 would have highlighted negative performance. Such a performance highlight could either have enabled you to take the profits or do something else other than stare the stagnant performance.
7. Not Insuring the portfolio
Insurance need not be restricted to just life, cars and bikes. Even your stock portfolio requires insurance lest you run the risk of swinging along with the market. Like life insurance or other insurance products, portfolio insurance also will cost you money. But that cost is bearable given the downside protection it offers during sharp market downturns. Simple portfolio insurance example is to buy put options. Fortunately Indian markets now offer such portfolio insurance products. Even where you have investments only in mutual funds or ETF’s (for some reason many think they are safe investments!), you still need to insure your investment as your fund manager will not do it for you.
8. Mistaking performance for stability
When a stock performs well on the back of good company performance, we can mistake it for stability and hence may fail to check the story at regular intervals. Turning points, even in a good scenario, can be sudden and can wipe out gains in no time. A recent example is Motherson Sumi, an auto ancillary company. Like Eicher, the company had a long streak of ordinary performance and then had a nice takeoff. From Rs.88 in Sept 2013, the stock went up to Rs.348 in August 2015. Not many paid attention to its over dependence on Volkswagen (40%) and when bad news came in the form of scandal involving VW, the stock price of Motherson Sumi plummeted 42% in just two months!
9. Mistaking Performance for Skill
The biggest mistake you can make as an investor is to attribute success to your skill and failure to luck! (or bad luck!). The performance of a company and therefore its stock price is dependent on scores of quantitative and qualitative factors. While through skill you may be able to crack the quantitative part, it is a time-consuming and innate exercise to look through a company qualitatively. Qualitative factors include a deep understanding of the Board and executive management, their track record in terms of corporate governance, ethical conduct of the company and its owners, employee remuneration, tweaking books to show a certain performance number, political connections, front running the stock, insider trading, etc. Either you devote a considerable time unlocking these essential elements to develop the needed conviction or go with a gut feel on the subject. Given our inability to find time, we normally resort to the second tactics. When your decision turns positive, you feel you are in control of this process. Always double check the story during a good performance period just to be sure you can keep the profits.
Honestly I have been through all these mistakes in one form or other. This list of mistakes may not be exhaustive and I may unravel many more as I reflect.