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Thursday, May 19, 2011

Stock market quiz for new investors – a discussion

Before getting into a detailed explanation of last week’s stock market quiz, I would like to specially thank all the readers who attempted answers. Answering questions in an open forum requires a certain amount of courage. There is always a fear that you may get the answers ‘wrong’.

That is why the answer options were provided in a way that apart from a few obvious ‘wrong’ answers, readers could choose from several ‘right’ answers. This is an important point for new investors to appreciate. If you are going to be successful stock investors, you need to have your own strategies and tactics. If a system or style works for you, it is a good system. Otherwise, you need to tweak or change it to make it work.

Let me provide the answers that I would have chosen – as a conservative, risk-averse, long-term investor:

1 (d); 2 (b); 3 (d); 4 (d); 5 (e), and I will explain why. That doesn’t mean that my answers are ‘correct’ – it merely reveals my investing style, which can be summed up as ‘Safety First’. By the way, there was a typographical error in 1 (d), which reader VJ had pointed out.

Why 1 (d)? Karan summed it up nicely in his answer, and this was really the only ‘correct’ answer in Q1. The other options are too risky. The answer option I didn’t provide was: “Nothing – because I do not buy or sell on tips”. Every one would have chosen that option!

Small investors should stay away from small-cap stocks in general – because of low liquidity that makes buying and selling difficult, and due to lack of financial staying power through tough times. But if you do buy a small-cap, maintain a stop-loss of no more than 8%. A 20% price drop may be a sign of worse to follow – so get out.

Why 2 (b)? Most of you chose option (a), which is not ‘wrong’. As a general rule, don’t average down because you don’t know how far the stock may fall. This is a rule for small and mid-cap stocks. For large-caps – if you have done your homework before buying, a 10% drop in price is a good opportunity to add. (Follow the thumb-rule of never buying near a 52 week high.)

Why 3 (d)? No one chose this option, except Venkat. Most chose (c), which isn’t ‘wrong’. The situation described is called a ‘panic bottom’ – which usually happens during the first or second stage of a bear market. Such bottoms are invariably broken, and the stock tends to fall much lower. So you may be better off by closing the trade, and buying lower again after the stock bottoms out.

In such stocks, it is good to keep a stop-loss between 8-15% – to avoid a 50% drop.

Why 4 (d)? Almost every one chose this option. The point I was trying to make is that investors get hung-up with round numbers. If you buy at 10 you want to sell at 15 or 20. If you buy at 50, you want to sell at 75 or 100. Markets rarely work to suit your convenience. In a low-priced stock – which investors should avoid in the first place - it is better to start taking profits home whenever they are available. Most investors get killed when they go out to make a killing!

Why 5 (e)? Only Saurabh and Joe chose this option. There are two points here. In a step-wise up move, prices tend to find support near previous tops. Those are good places to add. Since we don’t know if 55 was a previous top or not, we would not know if the correction will stop at 55 or fall further.

Also, it is a good idea to take profits at a 52 week high – more so because the original investment has doubled. Remember that you make money only when you sell. So you need to have a selling plan when you buy a stock.

Venkat gets the hat-tip for the ‘best’ answer. His responses suggest that he isn’t a ‘new investor’ any more!

Thanks once again to all who participated in the quiz. For those who didn’t participate – hope you will be able to pick up a few pointers from this discussion to improve your buying and selling.

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