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Thursday, March 18, 2010

How to overcome Uncertainty in Stock Market investing

Many investors shy away from investing in the stock market because of the uncertainty of making any profits. A fixed deposit in a bank or an investment in a PSU bond has much less uncertainty. You are pretty much assured of getting back your invested capital, as well as earning some interest income.

In the stock market, there is uncertainty about receiving any income because a company is not obliged to pay any dividends even if it is making super profits. For example, a profitable company like Bharti Airtel paid its first dividend only in 2009 - 7 years after going public.

And there is uncertainty about getting back your invested capital. If you had bought Bharti at 600 in Dec '06, and sold at today's closing price of 300 (2:1 split adjusted) you would have actually lost a small part of your capital due to brokerage and tax payments.

But these are uncertainties that can be managed and, to a certain extent, measured. What we term as 'risk' is nothing but the possibility of having an unfavourable outcome. We can try to reduce the risk by quantifying the uncertainty of the outcome. How?

Let us say, you plan to buy 100 Tata Steel shares @600. You assign a probability of 80% that the stock will test its recent high of about 650.  There is also a 20% probability that the stock may drop to its 200 day EMA at 520. That means a 80% chance that you will make 5000 but a 20% chance that you will lose 8000. Your risk of loss can be quantified as: (600-520)x100x0.20= 1600.

After looking at the numbers, will you still decide to buy Tata Steel at 600? There is no reason why you shouldn't - specially if you have learned to set a stop-loss for all purchases. (Don't know how to set a stop-loss yet? You have only yourself to blame - because it is clearly laid out in Chapter 2 of my FREE eBook.)

What stock markets dislike are uncertainties associated with external factors and events, such as rate of inflation, interest rates, quarterly earnings results, oil prices, war, terror attacks, political climate. Adverse effects of such uncertainties usually get reflected immediately with 2 or 3 days of correction. Smart investors use such dips to buy.

But the worst uncertainty is about the state of the economy. If there is a possibility of a recession or a depression, stock markets tend to tank as investors rush to the exit doors and invest their money in safer havens.

The best way to overcome the fear associated with uncertainty is to always stay well-informed about the business and economic environment around you. Most business magazines and newspapers have web editions that you can browse without leaving your seat. Also visit web sites like CNN Money, FT and WSJ Marketwatch to get an international perspective. Make it a daily habit.

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